ESG investing: the rising trend

Massachusetts Institute of Technology (MIT) research has found that, on average, rating providers agree on the environmental, social, and governance (ESG) performance of the companies they evaluate only about 66% of the time. This is why, for investment professionals at UBS Asset Management, ESG integration involves enriching third-party ratings—not only with the asset manager’s own scores, but also with insight from a specialized, in-house team of analysts who can dig deep into the data, says Nicole Lim, an equities specialist within Concentrated Alpha, an active equities team within UBS Asset Management.

The Concentrated Alpha team is comprised of bottom-up stock pickers who focus on the fundamentals of individual stocks. One of the funds the team manages is the European Opportunity Unconstrained strategy, a longshort equity vehicle that invests in European companies. It isn’t a specialized ESG- or sustainability-focused offering per se, but rather a pure investment portfolio that in 2017 had ESG data integrated into its stock selection and portfolio construction methods.

To make ESG an integral part of the strategy, Concentrated Alpha looks for signals in ESG scores and ratings. The team uses the ESG risk dashboard—which employs data visualization software that UBS uses for a variety of research frameworks—to display companies’ ESG performance in columns via a graphical user interface. To deliver the ratings and scores to the dashboard, UBS pulls in data from third parties, including MSCI and Sustainalytics, and its own ratings. These proprietary ratings were developed by the SII team and academic partners, as WatersTechnology reported earlier this year, to judge whether a company’s products or services promote the United Nations’ sustainable development goals under the UN Global Compact.

UBS’s proprietary methodology and MSCI rank companies on a scale of 0 to 10. Sustainalytics, however, uses a slightly different approach that produces an absolute risk rating that ranges from “severe” to “negligible”.

“Our analysts convert this risk rating into something that can be numerically scaled from 0 to 10 as well, so now we have a scale of 0 to 10 across all three providers, and we take the average scores across those three,” Lim says.

The average score is the figure that is used to flag companies based on risk. If a company’s average falls below three, the dashboard will display a red light next to its name; it will also flag whether it scores poorly for governance, or seems to breach the UN goals. A green light, on the other hand, means no risks are flagged.

“We are still able to see granular breakdowns of how MSCI [or] Sustainalytics rates the company, but the consensus score, which is the average column, is what we look at and take as a flag,” Lim says.

Questioning the flags

These flags are not taken as investment signals on their own; in fact, they are merely the beginning of the engagement with the SII analysts.

“This risk dashboard is good in the sense that it gives us a very quick view of what is going on [and of] what companies are flagged on what kinds of measures. But it’s important to note that we don’t rely solely on these ratings, because a lot of them are not correlated,” Lim says. “The beauty of being in a big firm with dedicated ESG resources is that we have a team of independent analysts who can step in and say, ‘OK these are companies that are flagged, but are these flags justified?’”

The analysts might confirm that a company really does score poorly on ESG factors. Equally, though, they might find that there isn’t really a risk.

Often, for example, a firm might score poorly simply because it has immature disclosure practices rather than because it presents a material ESG risk.

“This is where it gets interesting, because in a portfolio of 60 stocks with, say, five stocks flagged, we bring those five to the analysts and say, ‘Can you do a bit more work on these names?’ And they will come back to us with feedback on what they think, and their own risk ratings,” Lim says.

In turn, the Concentrated Alpha team are not bound by the analysts’ recommendations but can leverage them for stock selection. “We are investors at heart: it’s common sense that if you want to generate long-term financial returns, you need to invest in companies that are sustainable in the long run,” Lim says.

Concentrated Alpha portfolio manager Max Anderl, says that in some cases where the analysts have verified that a company has poor disclosure capabilities, rather than material ESG risks, his team and the SII team have worked with the business to improve its disclosures. He cites the example of a fairly young online pharmaceutical firm.

“The company was flagged as high risk [on the dashboard]. It was a problem of disclosure, and we said, ‘We can overcome it.’ We had this conversation with the CEO, rather than the chairman. He fully acknowledged the issue, so we sent him examples of best practice disclosures, and he said he is committed to making better disclosures happen. With younger companies, sometimes it can be a bit of a burden for them: they were growing strongly, but they lacked resources and faced the kinds of challenges that young, growing companies have. Nevertheless, they said they would put more effort into disclosure,” Anderl says.