ESG: It’s not just great to be good
Investing according to environmental, social and governance criteria can be done in various ways, with continuing development of filters and ways of analysing companies. As the market in ESG indexes and investments linked to sustainability matures, there is a wealth of opportunity for research that delivers innovative ways to buy this exposure.
Investing according to environmental, social and governance (ESG) criteria can be done in various ways, with continuing development of filters and ways of analysing companies. As the market in ESG indexes and investments linked to sustainability matures, there is a wealth of opportunity for research that delivers innovative ways to buy this exposure
There is no single benchmark for investing according to environmental, social and governance (ESG) criteria, while an established convention of what fits into this category remains elusive. ESG is neither an asset class nor has it been proven to be an equity factor.
And, while assets under management incorporating some ESG criteria amounts to $30.7 trillion globally, questions remain over the definition of sustainable investing.
There are two approaches. The first, more established, is that ESG is a feature intrinsic to the operations of many companies and, to invest in the best of these companies, you need to look at how much better their credentials are. You can also select companies that have gained momentum in their efforts to improve their ESG credentials.
This fundamental research approach has provided returns and pleases the many investors that want it all – and for whom ‘all’ must include a good return on investment alongside a positive environmental or social impact. Societe Generale has created research reports revealing companies that demonstrate fine and improving ESG credentials while offering returns that, over the past five years, have beaten the Stoxx 600. Clearly, and rather obviously, financial performance or alpha generation will have to remain part of the equation.
To identify what is financially relevant and material, Societe Generale reviews information from the ESG ratings agencies – Vigeo Eiris, Sustainalytics and others – before sitting down with mainstream analyst colleagues to identify pragmatically what makes sense financially, without taking an ethical or philosophical stance, according to Yannick Ouaknine (pictured), head of sustainability research at Societe Generale in Paris. “There is no direct link unless there is a reputational factor,” he says.
ESG alongside factors
The second way of looking at these investments is to delve deep into preferred investment styles, which means looking at equity factors, and then thinking ‘sustainable’. This approach also takes the view that the two philosophies of superior investment returns and ESG can and should run alongside each other. “We will be using equity factors alongside ESG factors to create a more sensible strategy, because more and more managers have to demonstrate they are seeking to improve the ESG profile of their portfolio,” says Georgios Oikonomou, a quantitative analyst at Societe Generale in London. “The question is, how do we integrate ESG into the investment process in a more efficient way and without a performance penalty, so it is possible to improve the ESG rating of your fund without losing performance?”
To make this happen, the bank uses its expertise in equity factors. “We try to maximise the ESG rating in the portfolio, but without creating biases in sectors and factors,” says Oikonomou. “For example, if there are companies that score well in ESG but are expensive to incorporate in portfolios, we may need to correct this. We will still screen out, but in a way that we stay close to the benchmarks. It’s about enhancing the portfolio and incorporating ESG at the same time.”
The analysis is based on standardised ESG ratings from Sustainalytics, and those who have done quant or used data providers will appreciate the fact the company has no backfilling of scores. “They have been in this space for around 20 years and the scores we are using today are the ones they have produced over time, so there is no backfilling, which is critical for the data analysis,” says Xavier Dubourg, head of quantitative investment strategies equity trading at Societe Generale in Paris. “We had access to the point-in-time scores, which is very good. This may restrict the investment universe, but we stick to the most liquid names, so that’s fine with us.”
When an investor wants to buy into the best ESG names, one of the preferred approaches is intra-sector, where they invest in the best-in-class or top ESG names in each sector, although many investors retain a desire for best-in-universe. “It can often make more sense to compare stocks from the same sectors with regard to ESG,” says Dubourg. “A bank does not have the same material ESG key performance indicators as a chemical or consumer company would have, so it makes sense to look at it by sector – hence the name ‘best-in-class’ approach, as opposed to ‘best-in-universe’.
“The numbers tell us, from an investment standpoint – performance-to-volatility, performance-to-drawdown – that you are better off following the best-in-class, rather than best-in-universe route. Both the numbers and the rationale are consistent.”
This is the first of two articles on ESG at Societe Generale. The second will appear tomorrow (Thursday 31 October).