Finding your way to a new destination is a piece of cake nowadays: just tap on your smartphone or car navigation app and follow its digital directions. Before the digital communications revolution, we needed paper roadmaps. Even if they were accurate, they were unable to take weather and traffic conditions into account.
One could say that environmental, social and governance (ESG) aspects add to an investment process what modern navigation tools have added to paper maps. Investors are now more informed and better equipped to make decisions. ESG integration can add extra dimensions, challenge existing perspectives and improve the adaptability of an investment process.
Various routes to the same destination
While there is significant debate about the terminology used around sustainability, ESG integration is straightforward at its core: it is about integrating E, S and G aspects into the investment process. Different players do this in different ways. For us at NN Investment Partners, ESG integration must at minimum be done in a systematic and auditable manner and should be documented in the investment case. It should also be much more than negative screening, which only says something about what you do not want to be involved in from a normative point of view. We believe this should take place before ESG integration even comes into play.
Integrating ESG factors is not necessarily identical for equities and fixed income or across all sub-asset classes, as there are often large differences in data availability and coverage of investable securities. In addition, there has been much more research on the equity side into how ESG integration affects risk-adjusted returns. Furthermore, locating the added value of ESG integration differs between asset classes. By nature, fixed income investors tend to focus more on the downside risk, as their upside is much smaller than in equities. The variety of fixed income instruments also plays a role – for example, assessing a government bond requires a different approach than assessing a corporate bond, and what is relevant in emerging markets might differ from developed markets. This suggests a tailor-made approach is needed to define what matters most to which asset class.
Still, a common denominator across asset classes is reputational risk, which plays a bigger role than ever with many recent examples of scandals, court cases and natural disasters. As a result, ESG integration is often framed as identifying ESG risks. We are convinced its scope is bigger than that and that it can also help investors identify the winners. Incorporating information on E, S and G aspects can also be used as a tool for engagement. Investors who have a deeper understanding of a company are in a better position to have a fruitful dialogue, ask critical questions and encourage improved disclosure.
While it sounds obvious that investors should take into account as much relevant information as possible, investors often have different reasons for incorporating ESG criteria.
- A values perspective: because you seek to incorporate certain views by assessing ESG data, such as giving more weight to poor labour standards or encouraging equality in the workforce
- A pure risk-adjusted return perspective: because you believe that ESG integration will help you identify winners and avoid losers
- A thematic perspective: this is also to identify winners, but linked to a strategic theme, such as investing in renewable energy and the transition to a low-carbon economy.
Often, investors apply a combination of these perspectives. The values perspective applies to all our investment strategies, as we have identified certain activities that we do not want to be involved in at all, such as tobacco and oil sands. ESG integration aims to include all material information to come to a balanced decision, which does not imply a high level of exclusion. We believe ESG integration should be used to enhance a portfolio’s risk-adjusted returns by selecting the best investments based on material ESG factors, with the aim of improving risk and return characteristics. The more thematic perspective is clearly visible in strategies like our green bond, infrastructure debt and impact equity funds. In the end, what matters most is that we find strategies and solutions that are in line with our own core values while matching our clients’ values and preferences.
To be sure, ESG integration is not always easy. There is a lack of standardization when it comes to reporting and disclosure, which sometimes makes it difficult to find accurate and comparable data. Coverage can also be quite limited in certain areas, for example in emerging markets. Or the opposite may be true: an overabundance of data makes it difficult to identify material data points. It can also be tough to find a balance between E, S and G – what if a certain investment benefits the environment a lot but the social aspects are abominable? This requires careful consideration and brings us back to the importance of engagement, which can be used as a tool to address the weaker aspects.
Imagine you have this new destination to travel to – would you still use a potentially outdated paper roadmap to find your way? Or would you make use of the large pool of information that is now available, whatever its imperfections? That old paper roadmap is still the foundation of your journey, just as financial analysis remains at the heart of investing, but you might discover new routes and different views along the path that your ESG-upgraded navigation tool has suggested to you. Enjoy the ride!
Valentijn van Nieuwenhuijzen, Chief Investment Officer NN Investment Partners