Sustainable investing was once considered an exception in the investment decision making process, but today, with the credibility and importance of environmental, social and governance (ESG) integration growing substantially, it has now become an expectation.
This in turn creates an opportunity for active managers as the real impact on investments is becoming more visible.
The industry has witnessed a growing number of signatories to the UN PRI which now exceeds 2,500 and represents over $80 trillion USD in assets.
This growth has seen immense innovation and product development to meet the needs of investors interested in sustainable investing. The flow of interest into strategies that integrate ESG factors and the growing awareness of academic research supporting the benefits, are encouraging more and more asset managers to practice ESG integration.
Further, part of the EU sustainability finance package is to ensure that ESG risks and opportunities are embedded in investment decision-making structures. With this kind of regulatory pressure, it’s not hard to imagine that momentum will build for investors to change their portfolios.
As climate change becomes more widely recognized as an investment issue, it will mean that ESG is to be a defining trend of the 21st century and play a critical role in addressing some of the challenges through the delivery of investment offerings.
Integrating ESG considerations into investment decision making
ESG analysis was often done through a screening process, mainly to filter out certain investments from an ethical perspective. Often this analysis was done by a separate ESG team that simply provided this overlay to the “mainstream” analyst’s research process. We now see ESG analysis and integration enhancing the underlying research process to better account for material sustainability risks that can negatively impact financial performance.
ESG integration includes an analysis of intangible factors and “softer” items that relate to how a company deals with its environment, how it addresses its labor force and supply chain and how aligned the management team is with outside shareholders. This all comes in addition to reviewing the financial data of a company.
A lot is said about the materiality of ESG issues in investment decision making -we believe integrating ESG into the investment process hinges on the notion of financial materiality. The focus of ESG integration on financial materiality is reflected in the ESG Material Issues Framework that the UBS Sustainable Investing research team has developed. With sustainability encompassing a number of topics, financial analysts need to consider the factors that have the potential to impact the company’s financial performance.
Factors impacting the investment thesis
The ESG Material Issues identifies the 3-5 most material factors that can impact investment theses across 32 different industry sectors. This orientation towards financial materiality helps to ensure a more detailed analysis of a companies' sustainability performance, by focusing on those aspects that can impact the bottom line and therefore investment returns.
Addressing sustainability risks
As well as focusing on material issues, ESG integration requires a mitigation of sustainability risks. Sustainability risk mitigation has shown to be a minimum requirement for virtually all investors, regardless of their explicit commitment to sustainable investment. In mitigating this risk, UBS does not simply negatively screen, but rather undertakes a prudent consideration of material risk factors that could negatively impact the company's performance.
The importance of ESG risk mitigation for investors is supported by a number of recent studies demonstrating that the primary outperformance from sustainability arises from its impact on company specific risks. In a recent article, MSCI demonstrated that the primary driver of outperformance of more sustainable portfolios rose from avoiding negative event risk in companies with weaker sustainability performance.
The infamous examples of BP, Volkswagen, Equifax, and Petrobras, all had weak sustainability profiles prior to the events that led to significant declines in the share price. Similarly, UBS Asset Management’s own quantitative research found that the outperformance from sustainability arises primarily on a risk-adjusted basis. Thus, avoiding significant material sustainability risks in the portfolio can help avoid companies with elevated potential for event risk, that in turn can lead to significant headwinds in portfolio performance.