A major focus of responsible investing over the past 10 years has been on ESG integration into active equity funds.
The evaluation of ESG issues may be qualitative or quantitative, i.e. altering expected returns, costs, or other financial metrics such as the discount rate applied to discounted cash flow analysis. In this context, ESG integration is often used in investment strategies that are designed to deliver out-performance, particularly in the listed equities asset class.
The premise underlying integration is that for some sectors and some companies, their exposure and response to ESG issues can materially affect their financial performance. The intention is to identify those companies that are likely to deliver lower than expected financial returns due to poor management of ESG Issues and the converse – those that are expected to outperform due to superior management of ESG issues, and alter investment decisions and stock weightings accordingly.
This investment approach involves analysis of:
- the extent to which particular sectors are exposed to and may be exposed to risks related to ESG ‘mega trends’ such as climate change, water scarcity, the explosion of chronic diseases, demographics etc, or positively benefit from them
- the risk exposure of individual companies to ESG issues and how effective their management of them is; and
- the extent to which individual companies’ business strategies take into account ESG challenges and deal with them proactively.
When selecting fund managers, pension funds should consider that activities portrayed as “integration” often merely amount to simple screening, whereas integration done well is a powerful method of fundamental analysis. One way to ascertain the effectiveness of an investment manager’s integration approach is to consider the price of an investment firstly with and then without ESG factors accounted for.
- PRI (2018) Developing an active ownership policy in listed equity:
- PRI Intro Guide on Screening:
- PRI (2020) Investor tools for passive investment
- PRI (2018) Developing an active ownership policy (guidance on stock lending)
- ICGN (2007): Securities Lending Code of Best Practice (2007)