Recent regulatory developments suggest that environmental, social and governance (ESG) investing is neither a fad nor a subjective enterprise.1 Rather, it has become a critical part of day-to-day investment management. As I stated in our recent ESG Outlook, global investor commitment to ESG- and impact-themed investing evolved from a question about why ESG is important to how it can be most effectively implemented.
A growing body of research supports a positive relationship between high ESG characteristics and improved investment outcomes.2 However, as an investment factor, ESG continues to lack uniform definitions and a solid methodological baseline for security analysis. There are no generally accepted accounting principles (GAAP) for ESG.
The explanatory effect of ESG on returns in the context of stock market crises also remains subject to debate.3 As a result, popular guidance based on ESG overlays (e.g., ESG analysis separated from fundamental analysis) or inserts (e.g., top-down SRI screens) runs the risk of obscuring which ESG issues are truly financially material and for what time horizon they will affect issuers.
At American Century Investments, we believe that a bottom-up ESG integration approach that is investment-led and focused on materiality is optimal. In our view, such an approach can increase portfolio diversification and maximize the integration of both ESG quality and alpha-related inputs.
We believe this results in a 10-step process to achieve a successful ESG integration strategy:
ESG factors can be integrated in multiple ways. An ESG integration framework should therefore be flexible and align with the particulars of a given investment strategy. For example, ESG teams may want to consider the following:
The number of ESG specialists aside, systematic ESG integration cannot be achieved unless fundamental analysts and ESG specialists work together. We aim not to substitute fundamental analysis but rather to augment it.
Financial and ESG information must be considered concurrently . The objective is to ensure investment analysts and portfolio managers participate in the ESG assessment by allowing them to provide input regarding the financial materiality of ESG issues to which their issuers are or could be exposed.
Identifying ESG issues (aka ESG key issue mapping) should consider, and be corroborated by, the macroeconomic context and any relevant industry-specific competitive forces.
American Century assesses ESG materiality first at the macro and sector levels before assessing at the issuer level. Our macro assessments consider ESG issues that could potentially affect long-term global market dynamics and regulatory developments.
Given that not all sectors are exposed to the same macro ESG issues, our ESG team works with our in-house sector leads to isolate the issues that could potentially alter long-term, sector-specific competitive forces.
Although many investors think of ESG primarily as a risk input, it can also represent upside opportunities. Therefore, analysts should focus on both the ability of the issuer to manage potential ESG-related costs and/or liabilities and its aptitude for setting the firm’s strategic direction. It is also important to consider time horizon, as exposure to an ESG risk or opportunity may not materialize for five, 10, or even 15 years.
ESG assessments that are both risk-based and forward-looking can help assess an issuer’s downside ESG risk propensity as well as capture ESG upside potential.
As ESG demand grows, investors should be aware of the potential risk of a crowded ESG trade. Once a good ESG trade becomes public, its success may attract other investors, eventually leading to concentration and overpricing. Thus, investors should redouble efforts to be creative in unearthing ESG rising stars (i.e., issuers in earlier stages of business inflection or on the verge of improvement following a business misconduct controversy). Defining the risk appetite around ESG is key to helping provide diversification in the portfolio and reducing bias.
Investment teams should consider third-party ESG ratings and artificial intelligence and understand the drivers underpinning these opinions and signals. This is similar to how they consider credit ratings, sell-side research and quantitative analysis. However, they should do so while generating variant views to exploit any potential disconnects in external ESG research or quantitatively driven data.
We believe the financial materiality of ESG analysis should be supported by proprietary research based on combined ESG and financial variables with a focus on investment implications. Proprietary ESG assessments should also apply to various asset classes and be dynamic, capturing whether an issuer’s risk management practices are improving or worsening over time.
To effectively scale ESG integration efforts, proprietary ESG research should ideally be centralized and made accessible to all investment teams.
We engage with issuers that have weaker ESG performance relative to their peers but show room for improvement. This helps portfolio managers gain a more thorough understanding of the company’s approach to ESG risk management, including controversies and remedial actions.
We also use engagement to encourage an issuer to increase transparency on material ESG issues. If engagement fails to yield positive outcomes, portfolio managers could escalate their concerns by supporting ESG proxy resolutions, reducing the holding’s weight, or divesting from the issuer, among other methods.
There is no one-size-fits-all approach to ESG. As client needs and regulatory developments continue to evolve, so should the capabilities of investment managers. A manager’s ESG program should therefore be flexible and regularly reviewed against industry best practices and market trends. This may help managers to provide multiple ESG solutions in all investment disciplines, subject to client needs.
We believe that any new enterprise, regardless of the field, requires passion to succeed. Passion is the cornerstone of what American Century calls ESG “grit,” a trait that all of its ESG analysts share. The millennial generation has fully embraced, with passion, the importance of ESG issues. They are likely to expect genuine passion on the part of their asset managers as they seek investment solutions in an effort to secure their long-term financial viability.
The investment community’s conceptual understanding of ESG and its role in investment decision-making is continually unfolding. We believe accounting for ESG risks and opportunities is in line with fiduciary duty—it is not disconnected from financial returns. To successfully achieve this alignment, we believe investors must take an investment-led approach focused on materiality and fundamental analysis. They must also remain flexible to evolving client-specific values and guidelines. Learn more about American Century’s approach to ESG investing.
1Notably in Europe, which includes the European Union’s General Data and Protection Regulation, the Markets in Financial Instruments Directive, the European Green Deal Investment Plan and the Regulation on Sustainability-Related Disclosures.
2This relationship is strongest when it comes to governance as an effective proxy for performance on a broader set of ESG issues. See: Dan Hanson and Rohan Dhanuka, “The ‘Science’ and ‘Art’ of High Quality Investing,” Journal of Applied Corporate Finance, Volume 27 No. 2 (June 2015), pp. 73–86. See also Jeff Dunn, et al., “Assessing Risk Through Environmental, Social and Governance Exposures,” Journal of Investment Management, volume 16, no. 1 (2018); Albert Deschlee, et al., “Sustainable investing and bond returns: Research study into the impact of ESG on credit portfolio performance,” Barclays Bank Impact Series, 2016; Credit Suisse Global Research, “Investment Ideas: Sustainable investment framework,” 2012.
3See Demers, Elizabeth and Hendrikse, Jurian and Joos, Philip and Lev, Baruch Itamar, “ESG Didn’t Immunize Stocks Against the COVID-19 Market Crash”, Working Paper: August 17, 2020. Available at SSRN: https://ssrn.com/abstract=3675920 . See also Patrick Hubert and Aled Jones, “Understanding the characteristics of ESG ratings data,” FTSE Russell, October 2, 2020, https://www.ftserussell.com/blogs/understanding-characteristics-esg-ratings-data?utm_source=linkedin&utm_medium=social&utm_cam .
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
A strategy or emphasis on environmental, social and governance factors ("ESG") may limit the investment opportunities available to a portfolio. Therefore, the portfolio may underperform or perform differently than other portfolios that do not have an ESG investment focus. A portfolio's ESG investment focus may also result in the portfolio investing in securities or industry sectors that perform differently or maintain a different risk profile than the market generally or compared to underlying holdings that are not screened for ESG standards.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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