For institutional investors, ESG-related initiatives are ultimately about managing risk. As noted by the Organization for Economic Co-operation and Development (OECD), a poor environmental record may make a firm vulnerable to legal or regulatory fines/sanctions; socially, the mistreatment of workers and dissatisfied employees may lead to higher absenteeism, lower productivity, and weaker client servicing/relationships; and weak corporate governance may incentivize and/or enable unethical behaviors related to pay, accounting irregularities, and even fraud.1 For all these reasons and more, identifying and addressing material ESG-related issues germane to a corporation is a quintessential exercise in risk management – for the management of that company, for investment managers thinking about holding that security in their investment portfolio, and for asset owners concerned whether the manager is acting in accordance with fund policies.
Regardless of one’s views about ESG, its centrality to many investors is borne out by the rapid integration and growth of ESG-oriented retail and institutional investing. According to the US SIF Foundation, in January 2020 there were 384 investment managers and 530 institutional asset owners who had incorporated ESG principles into their investment policies.2 Further, Morningstar Inc. recently reported that the number of US sustainable open-end funds and ETFs reached 534 in 2021, almost double the number as of 2020.3 The AUM of those funds exceeded $350 billion, a 35% increase over 2020. Similarly, the number of signatories to the UN’s Principles for Responsible Investment has grown from about 250 in 2006 to almost 4,700 by the end of 2021, including around 700 asset owners. Collectively, these signatories represent approximately $121.3 trillion in assets.4
Globally, the reported sustainable investment assets under management now represents about 36% of all assets under management.5 This growth is, in large part, buoyed by strong regulatory tailwinds. Regulatory authorities around the world are enacting ever greater rules and regulations governing the conduct and standards surrounding ESG. The intent of these regulations ranges from aspirational to enhanced transparency to prescriptive and promises to continue into the foreseeable future.
ESG Oversight Challenges
In light of these developments, it’s easy to see why many industry practitioners argue that ESG analysis has applicability in every stage of a manager’s investment cycle: asset allocation, investment universes, portfolio construction, investment selection, risk management, regulatory/client reporting, and client oversight. Consequently, asset owners must have the internal resources to collect and aggregate the data, as well as sufficient internal subject-matter expertise to interpret the raw data and evaluate whether follow up is warranted. A further constraint is that current ESG due diligence on fund managers is typically limited to soliciting feedback directly from those managers, with no means of independently assessing and verifying the efficacy of the responses.
A potential solution to these obstacles is the use of ESG ratings. ESG ratings are intended to assess how well each company is addressing its respective ESG risks. In theory, the ESG ratings serve as a proxy for the massive raw data set that lies beneath. And practitioners can thereby utilize these ratings to exercise oversight of, or build, investment portfolios.
Unfortunately, because of the disparate and inconsistent nature of company disclosures, each ESG rating provider, by definition, must make important decisions about which data sources to use, how to weight various factors, and then apply its own ethical judgements and algorithms to the key considerations associated with each respective industry. Consequently, these firms often yield very different rating assessments. In fact, it’s not uncommon for a company to be rated very highly by one rating provider while simultaneously rated very poorly by another. This lack of consensus has historically limited the value of using any single ESG rating provider and undermines investor confidence in the validity of their assessments.
Oversight Solution – Consensus ESG Ratings
Happily, the application of artificial intelligence and machine learning to the consumption of ESG data has provided a solution to this problem. A few ESG rating providers have begun leveraging technology in a manner that consumes ESG data from multiple rating vendors (as well as numerous other sources) and optimizes that data to reduce the inherent subjectivity between any two rating providers. In effect this approach creates a “consensus ESG rating.”
In our view, the existence of ESG consensus ratings elegantly addresses the innate subjectivity associated with single-provider ESG ratings. For institutional investors seeking a balance between meaningful oversight and operational costs, portfolio-level summary reports that utilize consensus ESG ratings provide a meaningful and cost-effective oversight solution.
Certainly, ESG is not for everyone. Each asset owner must make their own policy decisions regarding ESG, based on their own fiduciary judgements. However, regardless of a fund’s institutional position on ESG, it’s important to be on top of this topic. For instance, if markets pump up ESG stocks (or penalize non-ESG stocks), the performance effects are real - irrespective of your belief. Further, if funds limit or prohibit the use of ESG considerations, it’s important to ensure that managers subsequently act consistently with those directives.
Either way, asset owners need simple ESG oversight tools to monitor (in an efficient and cost-effective manner) whether mangers are investing fund assets consistently with fund policies. In this regard, the use of portfolio-level ESG reports powered by independent consensus ESG ratings enable asset owners to quickly:
- Ensure managers are investing fund assets in-line with fund policies
- Monitor whether manager practices are consistent with their representations (to counter “greenwashing”)
- Better understand the key drivers of each manager’s ESG rankings (i.e., “ESG attribution”)
- Exercise periodic oversight to track how each portfolio changes over time (i.e., “ESG style drift”)
- Flag any ESG outliers
Conclusion
Utilization of consensus ESG ratings shifts the ESG oversight regime from being heavily based on a single provider’s data sources and subjective judgements/priorities toward a more quantitative statistical optimization of the marketplace’s broad consensus. More to the point, the use of consensus ESG ratings in a portfolio-level reporting framework minimizes, if not eliminates, the need for data-aggregation capabilities and internal subject-matter expertise. This in turn allows asset owners to quickly quantify and assess the degree to which ESG considerations are being incorporated into portfolio construction activities, and/or complying with fund policies.
Regardless of a fund’s position on ESG, such oversight is a hallmark of prudent fiduciary stewardship. Reports that utilize consensus ESG ratings offer asset owners greater transparency and increased confidence when developing high-level views on ESG-related issues. Bottom-line, whether used as a supplement to existing ESG-initiatives or as the primary means of monitoring ESG practices, portfolio-level ESG reports can now be a valuable tool that facilitates asset owner oversight of the evolving ESG ecosystem.
To learn more about the needs, use and benefits of ESG consensus ratings and portfolio-level ESG reporting, we encourage you to read, the full “ESG Portfolio Monitoring – Harnessing Consensus Ratings and Portfolio-level Reporting to Monitor Manager Investment Practices” whitepaper.
Sources- OECD, ESG Investing: Practices, Progress, and Challenges, (2020)
- US SIF Foundation, Report on US Sustainable and Impact Investing Trends, 2020
- Morningstar Manager Research, Sustainable Fund US Landscape Report 2021: Another year of broken records, (Jan 31, 2022)
- PRI Signatory Update, (Oct-Dec 2021)
- Global Sustainable Investment Alliance, Global Sustainable Investment Review, 2020