Overcoming the Challenges of ESG

By Guillaume Mascotto - July 13, 2018

Environmental, Social and Governance (ESG) investing continues to gain momentum in investment management. But investors interested in incorporating ESG factors into their portfolios face several challenges, including differing terminology, rating methodologies and disclosure standards.

1. Defining ESG Investing

First, there are no industry-wide standards defining ESG investing. Organizations and regulators have tried to define ESG and set guidelines, but their efforts have received mixed reviews. The numerous voluntary disclosure frameworks are confusing issuers. While institutions, such as pension fund managers, are concerned these top-down methods may impose on their beneficiaries' investment values.

The Multiple Methods of ESG Investing

Part of the confusion stems from the several popular ways of integrating ESG considerations into an investment process. Popular methods include:

  • Negative Screening (Exclusion): Screening and excluding companies with activities that do not meet an investor's specific guidelines.
  • ESG Integration: Including non-financial variables into traditional financial analysis to weight stocks based on ESG risk metrics.
  • Thematic Investing: Investing in companies aligned with specific themes (e.g., clean technology or gender diversity).
  • Impact Investing: Investing in companies generating measurable social and environment impact along with financial returns.
  • External Ratings Tilting: Overweighting or underweighting companies according to ESG ratings data from recognized third-party ratings agencies.

If investors do not understand how ESG is defined and, by extension, how to integrate ESG-related factors into their investment process, they may not understand how to properly mitigate the downside risks stemming from ESG issues.

For example, some investors may want to avoid specific areas of the market altogether but are unsure how far those exclusions should go. If investors pull assets from one area, like fossil fuels or defense, should they also pull them from related companies, such as those industries' suppliers or bankers? At what point does this start to restrict the return potential of the portfolio? Thus, we believe it's important to integrate ESG considerations into an overall investment process that seeks to balance ESG risk management with return potential.

2. Which ESG Methodology to Adopt?

Second, research and data providers may use different ESG ratings methodologies, which are still evolving. This can confuse investors; it may not be clear which "ESG indicators" or "key issues" are financially material, nor on what time horizon those factors will affect companies.

3. ESG Disclosure Frameworks

Finally, ESG ratings agencies rely on increased voluntary disclosure from companies to gauge their specific ESG risk management capabilities. There are no commonly accepted disclosure standards in this regard. Therefore, some ESG-related data may be estimated by third-parties and often may not be audited. There is a potential risk that disclosure of ESG data could become erratic over time and inconsistent across markets, further confusing investors. We believe this indicates a need for more reliable, standardized data as well as more disclosure on material ESG issues.

American Century Investments® ESG Approach

Since there are various ways for investors to incorporate ESG factors into their investment process, we remain focused on delivering solutions that meet our clients' evolving needs. Amid the variety of approaches to ESG investing, ESG integration may enhance diversification and performance potential. We believe this contributes to the social and economic viability of our clients' goals.

To do this, we've developed an integration framework and proprietary scoring model to expand our ESG capabilities. This methodology focuses on mitigating downside risk associated with non-financial dynamics, while also focusing on the opportunities that arise from how companies navigate those risks.

We believe ESG investing has the potential to achieve more than simply screening out certain industries. Instead, we see opportunity in actively including companies, rather than excluding them, based on how they contribute or positively react to ongoing market shifts that ESG issues can actively influence.

Guillaume Mascotto
Guillaume Mascotto

Our ESG Framework

Find a full breakdown of our framework and more in our latest white paper "ESG Continues to Evolve: Bringing Fundamental Analysis to ESG Investing."

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      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      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.