Putting ESG and sustainability into perspective in manager selection

Putting ESG and sustainability into perspective in

Manager Selection
ESG is a set of criteria/principles/factors, which is used to define
responsible and sustainable investing. They originate from the UN PRI –
United Nations’ Principles for Responsible Investments, launched in 2006,
with more than 1800 signatories today. UN PRI consists of 6 principles to
follow to be a UN PRI Signatory. The aim of UN PRI is to encourage long
term sustainable investments, and guide managers how to invest in a
Mia Söderberg responsible and sustainable way. The ESG- factors are not something that
Senior Portfolio Manager is regulated or have a set and accepted definition, it is only a very loose set
Nykredit Asset Management of words. This makes it very difficult to measure, valuate or even define
since different players in the financial industry interpret, implement and
Mia Söderberg has more than
20 years of experience in the
use these three factors in many ways. It is also the basis of an enormous
financial industry and is amount of reporting instruments, stock exchange ESG practices,
considered as an ESG & stewardship codes, memberships, corporate disclosure requirements and
Sustainability expert. She was
recently awarded by political initiatives, which all interpret what to focus on differently.
Investment Europe as
Personality of the year-
Nordics within the EuropeanSustainable and responsible investments are the fastest growing
fund selection community.
segments of the investment universe today and is accelerating.
Sustainable investments are no longer for tree huggers only, but bring
new tools and transparency and offer professional investors the opportunity to build strong
portfolios and generate a better and more sustainable return. The ESG-area is a dense jungle to
penetrate. In this article, I will try to bring a little order in an attempt to make it easier to understand
for those who are new to ESG and sustainability.
Putting ESG and sustainability into perspective in manager selection

Going through the E, S and G

E- Environment
Environmental considerations when choosing the companies you invest in can be made in many ways.
The range of ways it is interpreted is endless. Some investors only avoid the worst obvious offenders
and feel they have taken the E factor into consideration, while others go all the way to find the
companies who develop and use the latest technologies and knowledge to find the solutions to the
most relevant environmental challenges. Fund managers and analysts can look at how corporations
are dealing with issues such as energy efficiency, greenhouse gas emissions, carbon footprint,
preservation of forest and water life, chemical use etc. Fund managers can also choose to buy the
ones who already do well in these areas, buying the sector leaders, or buy the corporations that make
the largest changes towards a more sustainable operation, it is all about how ambitious they are. What
message they want to send to the fellow investors and the industry. How to interpret the E in the ESG
setup can reach all the way from negative screening with relative low thresholds to the forefront
investors in the Impact investing area.

S – Social
The S stands for Social. Having social considerations in the analysis of corporations in an investment
process can involve taking considerations regarding factors such as staff turnover, workers’ rights,
how the staff are treated, if they are paid a decent wage, how a country/corporation is respecting
human rights, gender diversity, workers health and safety, social impact on the society etc.

G - Governance
The G stands for Governance. Taking governance issues in to consideration is the most common and
widely used of the three letters by managers. Many fund managers put the G as the most important
factor to consider. This is very rational since the G is crucial to obtain the S and the E. Governance
issues are usually also of great importance to managers who not necessarily see themselves as ESG-
investors. The G focus on subjects such as corruption, management of the firm, board members and
leaders in the corporation, litigation risks, risk management, historic conflicts and the companies’
ability to handle and solve it etc. Academic studies have shown that strong environmental and social
standards stem from a good governance structure, why it is of great importance.

How managers understand it.

Since there is no regulated standard, or common practice or measurement there is almost as many
ways to interpret ESG-investing as there are fund managers, selectors and fund companies.

Problems - Some fund companies have an interesting ESG agenda, but the managers have little
interest in it. Some Fund companies are signatories to UN PRI but do not at all live and breathe the
purpose of ESG investing. The grade UN PRI give the managers is not disclosed and made public, it is
up to the fund companies if they want to reveal it or not. Some managers think it is enough to screen
out the worst offenders and some use a score card where good result in the G can compensate for a
lousy result in the E and the S. Others use a scorecard but only adjust their positions a little after it,
they only let it affect their portfolio construction process to an extent that it doesn’t mess to much
with their usual process. Many managers try to go around or squeeze in the ESG factors just to be able
to invest the way they are used to.
Putting ESG and sustainability into perspective in manager selection

And better ways - Some managers see it as an opportunity to adjust their strategy and investment
process to make it more adaptive to the ESG factors since they believe it will sort out the companies
sensitive to stricter regulations that can impact their profits negatively. There are also managers who
look for the ESG stars since they believe these are the ones best suited to handle the future of stricter
regulations and find the products and services for the bright future. Many fund managers have
realized that having an edge competence in the ESG area will in the long run give them better more
stable returns since the ESG factors tend to lead you towards successful quality companies.

The range of how managers interpret and use the ESG factors and how they incorporate it in their
management of their fund is very diverse. Many funds use fixed quant factors to build scorecards,
negative screening, passive strategies built upon external ESG data, constructing their own smart beta
products with ESG data etc. The possibilities and ways ESG can and will be used are endless.

Why consider ESG?

The reasons to invest in the sharpest ESG managers is many.

 Returns- The market is increasingly demanding sustainable investments. In five years’ time, it will
probably be compulsory to take ESG factors into consideration if you want to attract both larger
institutions and well-informed retail investors. The market for non ESG-managers will probably
be scarce. This leads to massive inflows in funds who have proven good ESG managers. This in
turn will increase the demand for companies who have ESG as core values, and there will most
likely be a sustainability premium of significance. As an early adopter, you will probably benefit.

 Stability -Fund managers who are good at ESG investing will give you more stable returns, since
they use the ESG factors as an evaluation and risk tool, leading to better informed investment
decisions, avoiding companies running into problems. If it is a good fund manager with great ESG
skills he or she will also give you higher returns since they will invest in quality companies with
great ideas and knowledge, who serve the market with sustainable products and services
demanded, which we already have good examples of.

 Avoid scandals -Proper ESG analysis and management will likely make the probability for having
a position in a scandal company substantially less. BP’s oil spill and Volkswagen’s emission scandal
are examples of companies who most likely wouldn’t have been in a well-managed ESG portfolio
even before the scandals, Volkswagens leadership and management problems were well known
long before the scandal.

 Getting ahead -It is likely that companies in the

“No investor should be able to
future will be valued partly after their sustainability, it
will be a crucial factor when analysing their market argue that they can afford to
value. This will favour those who masters excellence in ignore the ESG performance of
the ESG analysis area and have done so for quite some the companies they invest in”
time and developed a successful analysis and process - Mathias Leijon, Global Co-Head of
regarding ESG investing. If you invest in a good ESG Corporate and investment Banking,
orientated fund, you will most likely benefit from this Nordea.
too.
Putting ESG and sustainability into perspective in manager selection

According to a recent study made by Nordea there are three very clear indications based on hard facts
and statistics, based on MSCI ESG scores, why it is crucial to take ESG factors into account.

 In Europe, the companies with the highest ESG scores have outperformed the poorest scorers by
more than 50% since 2012.

 Corporates which manage to improve their ESG scores and earn better rating strongly
outperforms the companies that see their ESG ratings decline.

 Among the top performers, the volatility in returns on capital employed is less than half that of
the worst ESG performers among the European listed companies.

This is in line with a large number of other research, which also claims there is substantial gains to
incorporate ESG in the investment strategy and process.

Source: “The hard facts behind why corporates should invest in ESG” Johan Trocmé, Director
Thematics, Nordea Research at Nordea Markets. Based on MSCI ESG-ratings.
Putting ESG and sustainability into perspective in manager selection

When are you compliant (and not)?

The dilemma regarding ESG investing is that there is no regulation regarding when you are compliant
or not, it is pretty much up to every manager and fund company to explain and show in what way they
claim to be ESG compliant. Some claim to be so since they are a UN PRI signatory, but a vast part of
the industry do not consider that enough. What ESG-compliant means and in what way it is
implemented in the portfolio is up to the different actors in the financial industry to decide. There is
no black and white, yes or no whether you are compliant or not, there is an endless scale of gray
shades in between.

Green washing or window dressing do exist and both can be easy to recognize but also sometimes a
bit harder. When holdings consist of stocks that are hard to fit into the scope of ESG integration in the
investment process there is a problem. Russian oil companies, especially the partly government
owned, are very hard to justify in an ESG-integrated portfolio, for many reasons. To have an ESG policy
that looks good on paper but is not in practice on asset management level are often revealed in the
holdings and in the explanations given by the portfolio
manager. If the strategy is run only on metric data, it is "What is often lacking today is
crucial to examine the process and systematic methods a holistic view about what
that ends up in a list of holdings, and make sure it is
sustainability actually means
consistent and makes sense.
for the asset manager and how
this is implemented in the
What should selectors look for? research, investment process
Philosophy and methodology – What are the basic and throughout the value
philosophy of the fund? To examine the portfolio
chain of the services it provides
manager’s philosophy and look for asset managers with a
very clear definition of what responsible and sustainable to its clients"
investment is is crucial. What it means to them and their - Martijn Oosterwoud, Head of
interpretation of ESG investing and how it is implemented sustainable and impact investing
in the portfolio is key. The fund company’s philosophy and specialists, UBS
ESG agenda is also important, but the examination can
never stop at asset management company level since it is rather common that the company agenda
is far more ambitious than the portfolio managers’ interest in it. Compare the company ESG agenda
with the managers philosophy, do they align, and does it show in the fund’s strategy, methodology
and holdings? How dedicated to sustainability is the portfolio manager?

Holdings – It is crucial when looking at ESG investments to look at the holdings. Do the holdings align
with the stated strategy and investment process? It is not rare to find holdings that at first look do not
fit into strategies, which claim to be ESG integrated or sustainable. The reason why it is there can be
a lack of actual ESG integration or can be very accurate and clever even if it at a first glance seems to
be misplaced. The list of holdings must be very thoroughly examined and a discussion with the
portfolio manager is necessary to understand why the portfolio consists of the present holdings and
in what way the stock made it into the portfolio. Does the portfolio manager have a view on ESG
investing that align with yours regarding what ESG really is?
Putting ESG and sustainability into perspective in manager selection

ESG Controversy- an interesting subject to discuss with the representatives of the investment product
of interest is their view on ESG controversies and how they handle them. This can vary widely but
there is not one correct way or answer. Some fund managers exclude the worst offenders by using
controversy data ranging from 1(low) to 5(severe) on company level, and research shows that
excluding the worst offenders can have a positive impact on portfolio performance. Others have their
own analysis department and try to follow the market development in the ESG area to obtain
information before it gets incorporated in widely used ESG-data, and benefit from changes in it. Some
managers don’t bother with this at all, rely on other kinds of analysis and data and have their reasons
for that. The interesting part is their view and their actions and controversy data can never be the one
and only level of assessment, it is only a small piece in the much bigger jigsaw puzzle.

How to use ESG / How far should you go

There are a vast number of ways to use ESG factor integration as a criterion in fund and manager
selection. What it all boils down to is how it affects the final investment decision in the portfolio
construction process and portfolio strategy. It is common to divide the ESG-concept into four under
groups or definitions depending on the level of dedication to the ESG agenda. Exclusion, ESG
integration, Sustainability focus and Impact investing and you as a selector or investor need to
understand what you are looking for and be well informed of the different levels of integration and
dedication. If you truly look for an ESG integrated investment, you need to make sure that ESG really
matters to the portfolio manager in a very hands-on way.

Since the market for ESG data, systems, scorecards etc. is huge, with over 400 different sustainability-
reporting instruments, the likelihood that you will encounter a portfolio manager only relying on these
products is likely. It is crucial to evaluate if the data and systems are used in a fruitful way or if the
data screening, filtering and scoring systems have hijacked the investment process.

Many asset managers emphasize the number of sustainability evaluation systems or sustainability
data they use, but the crucial point is how sustainability orientated the portfolio management really
is, which strategy does he use and what analysis is made, what methodology and investment process
is used and is it all consistent and makes sense?

The hands-on dialogue-based investment decisions usually lead to a portfolio manager with greater
insights and more deeply analysed investment decisions, and those usually give you all the information
you need in a very knowledgeable and structured way.

My experience tells me that it is often necessary for asset managers to meet the companies directly
and have a meaningful and engaged interaction and open dialogue to understand their vision an ability
to deal with sustainability related risks and opportunities that really matters to their performance.
Putting ESG and sustainability into perspective in manager selection

Ratings – dedication is not always shown in ratings.

There are many kinds of ratings, memberships, signatories etc. on the market, my view is that it can
be a part of a bigger picture, but it is impossible to assess whether a fund or an investment product is
truly ESG compliant and sustainable in your own view of what it means only by running a set of data.
Many funds use too much data and too many systems ending up in a box ticking exercise and a sea of
memberships or sustainability ratings. Where it becomes more important to a portfolio manager how
he is measured and what sustainability rating he scores rather than having a truly sustainability
focused agenda.

Do you know how many Dedication - A very dedicated manager can have an
agenda that diverges largely from a rating’s underlying
Morningstar Globe points Boston
setup, which makes it look bad when it is way better
Common Asset Management’s funds
than many of those with higher ratings or more
get for leading a coalition of memberships. The ESG data-based ratings do not give
investors to persuade banks to limit any credit to asset managers on their efforts on
coal financing? How many points shareholder engagements or brilliance in their
Trillium’s funds get for leading an investment strategy.
investor statement opposing North
Divestments is not always the solution. It rejects the
Carolina’s discriminatory bathroom
possibility to influence and push the company in a more
bill, part of an ultimately successful sustainable direction through active ownership. There
effort? And what about all the fund are accurate examples of very dedicated impact
managers that have pushed investing fund managers who do not have the highest
companies to stop funding sustainability rating since he or she invests in companies
organizations supporting climate with low scores because the companies owned come
denial, address the gender pay gap, from an even lower rating but have started a very
phase out antibiotic use, and much important journey. To uphold and encourage that
more? No points. Exactly 0. journey through active ownership makes a much larger
impact than to invest in those companies who already
- Cary Krosinsky, President and Co-
do well, and do not really make any improvements.
founder, Real Impact Tracker; Lecturer,
Yale College, Yale School of Distractions -The rating itself can also be misleading
Management, Brown University; since it often measures peer groups of companies in a
Editor/Author/Advisor: Sustainable sector or fund
Investing group and leads the "Standardized ESG ratings
investor to think that ratings are comparable over all sectors and create a risk of a lazy
fund groups which often is not the case. implementation of
Easy way out- Many asset managers see controversy and sustainability into asset
company ratings and sustainability data as an easy way out. There management, as it allows
is a lack of knowledge in the industry when it comes to sustainable analysts and portfolio
investing. Getting to know the depths of sustainable investing managers to "justify" a
takes time, energy, endless discussions and education. Many view rather than analyse
analysts and asset managers haven’t had the exposure to the topic and understand it."
and don’t know how to fit it into their work and how they look at
– Martijn Oosterwoud, Head
companies and investments. Ratings and bulks of data becomes
of sustainable and impact
the easy way out. Portfolio managers often prefer hard exclusion
investing specialists, UBS
rules and rating frameworks since they don’t have to spend time
Putting ESG and sustainability into perspective in manager selection

and efforts to educate themselves on the subject. With rating data and exclusions, they look ok and
can continue doing what they do without too much of a hassle. The problem with this approach is that
much of the necessary analysis is lost along with the asset manager’s ability to improve both analysis,
investment process and overall results as well.

Divergence- Holding-based ratings is also a problem since ESG data diverge largely. One company can
be measured differently depending on who’s data it is based on. There is no ESG-consensus on what
to measure, or how to measure it. Weather voluntarily disclosed data should be included or other
data than the data provided by the company itself. The correlation between two major rating systems,
Sustainalytics and MSCI is only 0,32. It is of course good to measure different ESG-factors, but since
there is no consensus on what to measure and how, it can be very confusing.

Unreflected importance -The problem with ESG operational

“The lack of agreement and
excellence data, is that there are so many factors that are
robustness among various ESG
important but aren’t reflected in that kind of data. The
effects or impact of the products or services a company
ratings and data sets is a
provide is not reflected in these data. Most serious constraint for some. But the
sustainability analysts would agree that a company’s actual good news is that fundamental
output in form of product and services is a crucial part of the investors can use ESG research –
assessment whether a company is sustainable or not. When both quantitative and
it comes to measuring ESG factors in companies in emerging qualitative – without waiting for
markets, the information is scarce and often unreliable and more perfect data sets. We have
therefore a rating on a fund covering that market or a found success over time by using
company operating therein is likely not telling much. an ESG lens as an additional way
The race for ratings does not rarely end up in a marketing of understanding a company’s
machine game rather than a more sustainable portfolio. business model and evaluating
The window dressing and green washing by asset managers its return prospects
to fit in to the rather tight ESG-shoe can be rather independently from the
extensive. market.”
On the positive side there are fund managers who have Karina Funch, Fund manager-
taken control over the lack of sufficient data and built their Brown Advisory US Large-Cap
own way to analyse and do research to establish a complete sustainable Growth
picture where the ESG factors fit in and improve their
investment strategy, gaining better, more stable returns.
Putting ESG and sustainability into perspective in manager selection

Taking it one step further – Impact investing, what is that?

Impact investing is to take the sustainability agenda one step further. Impact investing means
investing in companies as a mean to generate a measurable, beneficial social or environmental impact
alongside financial return. Sustainable investments are the fastest growing segment of the investment
universe today and impact investing is the fastest growing area within sustainable investing. Impact
investing will likely compete for the leader position on its own in a few years since the interest for this
kind of investments is immense.

Many investors start to realize that there is no trade-off between doing good, supporting a sustainable
future and getting competitive returns any more. Impact investing is not for tree huggers only, but for
the investors who want to make their capital work in more than one way simultaneously.

Impact investing funds often focus on special factors such as climate, food, health, poverty and water.
Lately there is several impact investing funds who aligned their strategy with the United Nations
ambitious sustainable development goals (SDG), where every investment must be linked to one or
more of the united nations 17 sustainable development goals. The goal is to give the investor social
returns as well as financial by investing in companies offering solutions for these challenges and create
measurable social and environmental impact.

Fund companies dedicated to impact investing often collaborate and have set up partnerships with
universities to develop a set of impact measurement metrics, to obtain a very accurate number of
lives saved or other specific numbers of impact. Impact investors often engage with companies they
invest in directly to obtain greater insight into impact measurement. The most successful impact
investing funds have often an extensive experience of impact investing reaching long back in time and
have attracted employees with leading skills on the subject and invested substantial means into
building up a credible organisation around it.

This kind of funds were only accessible for a very limited number of clients, usually the very large
institutions and pension funds, but now, since the interest has grown and demand for impact investing
is accelerating there is a growing number of products open even for the smallest retail client.

Even if there can be frustration regarding the lack of knowledge and the shortcuts thru quant data and
ratings in the financial industry it is slowly and truly making a very definitive movement. A movement
towards both more sustainable and impact investing especially since more and more investors
understand the financial gains it brings and the interest and search for more knowledge is increasing.
Every step towards more awareness and more knowledge and more attention, even if it sometimes
takes the path of marketing agendas and box checking exercises, all those steps are better than no
steps towards a more sustainable investment universe.

You want to be serious about investing in ESG-compliant managers? – do your own

analysis and be thorough, get up on the board and surf the sustainability wave.