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Environmental, social and governance factors can impact investment performance: lessons for active managers

Consideration of ESG factors has permeated the mainstream for investment management

In recent decades, the information advantage available to traditional and institutional active management has eroded, just as environmental, social and governance (ESG) factors have gained prominence in certain areas of asset management. Today, institutional active managers must look beyond standard financial information to uncover value, and ESG factors offer a compelling opportunity to augment investment decision-making with critical additional data sets.

This was the focus of a recent session sponsored by the Association of Canadian Pension Management and led by Andrew Sweeney, Vice President and Institutional Portfolio Manager at Phillips, Hager & North Investment Management.

Key insights

  • The information arbitrage opportunities for active institutional managers have diminished with the advent of instant and easily accessible financial data
  • Most institutional investors today say they rely on ESG, while research shows ESG is correlated with both risk mitigation and alpha generation
  • Institutional investors should be cautious not to rely only on ESG as a value driver; and should work to develop a comprehensive framework for understanding how alternative, non-financial sources of value can be integrated into investment decision-making

Standard financial information no longer produces pricing arbitrage opportunities for institutional investors

“If we go back in a time machine to when the investment industry was less mature," comments Sweeney, “most stocks were held by individuals and, as a result, institutional asset managers had an advantage: they had more, better and faster access to the information required to build and manage portfolios."

Over the last 30 years, however, this favoured position has eroded. According to Sweeney, financial data has become commoditized and standard financial information is now “a lemon squeezed dry" for the institutional investor, providing little if any additional 'juice' to portfolios.

At the same time, however, the variability of individual share prices has not diminished. Sweeney notes that, “In fact, the opposite remains true, as share price dispersion observed over time indicates persistent alpha opportunities. To generate alpha, active managers increasingly need to look beyond investment information statements and towards non-financial metrics, such as ESG factors.”

Using ESG principles to inform investment decisions

Most institutional investors indicate they rely on ESG principles in making investment decisions across a range of assessment criteria that could include a company's climate change or carbon emission practices and policies, board member diversity and community development.

Direct engagement with companies is increasingly key to deriving value from integrating ESG factors

A 2017 survey by RBC Global Asset Management (RBC GAM) found that nearly two-thirds of investors across Canada, the United States and Europe include ESG principles “somewhat" or “significantly" as part of their investment approach and decision making, rising to nearly 75 percent for investors in Canada.1

“Clearly, most institutional investors are aware of and thinking about ESG factors," comments Sweeney. “The question is, what do they think ESG is helping them accomplish?"

Are ESG factors risk mitigators or alpha generators?

Of the investors surveyed in the RBC GAM survey, 48 percent say they consider ESG factors as a risk mitigator in an investment portfolio, compared to just 24 percent of those who say they use ESG as a potential alpha generator.2

“This insight into how investors approach their investment decisions corresponds with the strong academic link between ESG factors and risk mitigation," notes Sweeney. ESG can allow investors to determine “which companies have healthier capital, more sustainable business practices, and ultimately, better long-term profitability needed to deliver the superior financial results that we want."

Financial data has become commoditized and standard financial information is now "a lemon squeezed dry"

The rise in attention to ESG factors also corresponds with the rise of the knowledge economy where assets are increasingly intangible. This has lent growing importance to non-financial factors that ultimately impact the financial results of companies. Over the past four decades, the market value of public companies has increasingly tilted towards intangible assets such as ESG factors and alternative sources of value creation. In 1975, only 17 percent of the value of companies trading on the S&P 500 was based on intangible assets, whereas by 2015 that percentage had risen to 87 percent, eclipsing the value of tangible assets in assessing company value.3

"Clearly, most institutional investors are aware of and thinking about ESG factors"

Tying all of these developments together, Sweeney notes that because the value of both intangible assets and ESG is “hidden from financials, it tends to be under appreciated by market participants, and can be a potential source of alpha."

Beware the fallacy of “box-ticking" and consider the importance of engagement

Although research supports ESG considerations as both a source of alpha and as a portfolio risk-reducer, the integration of ESG factors is nevertheless not necessarily a panacea for investors in search of alpha. Third-party ESG ratings are inconsistent and even a company with a high ESG score, one that “ticks all the ESG boxes", can falter or fail due to other factors.

Instead, emphasizes Sweeney, “direct engagement with companies is increasingly key to deriving value from integrating ESG factors." Engagement allows shareholders to obtain better disclosure of ESG risks and opportunities, and more effectively assess ESG factors. This clarifies information in advance of proxy voting and builds commitment to improve in areas where a company ostensibly lags its peers.

Proxy voting has also emerged as a powerful tool in stakeholder engagement since many voting issues are intrinsic to shareholder value and large shareholders, working together, can help improve the governance landscape in Canada and globally. The sharing of information and perspectives among large institutional shareholders is particularly important when assessing ESG issues for large global companies.

Sweeney further remarks that active managers should be careful not to fall into the “quantitative fallacy" of making decisions based only on quantitative elements or metrics while discarding all other inputs. These non-financial factors, such as ESG, can be important in helping to assess the value and potential of a company, he comments, “even though they cannot be counted." Keep in mind, he concludes, that “not everything that can be counted, counts; and not everything that counts, can be counted".

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