Is sustainability sustainable?
By Blake Pontius, Contributor
Given investors’ surging interest in combining financial return objectives with environmental, social, and governance (ESG) factors—a concept known as “blended value”—some may be tempted to dismiss this as a transient trend.But our journey to incorporate ESG factors into our fundamental analysis has reaffirmed our belief that the emphasis on blended value will reshape the asset management industry and the sectors that comprise the global economy for decades to come.
Shifting demographics and other long-term trends are underpinning the growing importance of ESG factors.
Demand comes from a broad investor base, including institutions and individuals—in particular women and millennials, who are controlling more wealth and have a higher interest in sustainability than other groups. Geographically, interest is expanding beyond traditional boundaries such as Europe into Asia. Japan’s $1.5 trillion Government Pension Investment Fund, for instance, is placing more emphasis on sustainable investing.
During the financial crisis in 2008, the top risk factors identified by corporate executives were mostly economic, including asset-price collapse, a slowing Chinese economy, and the oil and gas price spike, according to the World Economic Forum’s . In 2018, four out of the five top risk factors are environmental or societal: extreme weather events, natural disasters, failure of climate-change mitigation, and water crises.
In short, we’re seeing ESG risks become higher priorities for corporate executives. This is influencing how investors view the risks and opportunities facing companies.
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While there is still some hesitation among investors about the value proposition of ESG integration and some perception that it may conflict with their fiduciary duty, a growing body of research debunks the idea that there is a tradeoff between financial performance and sustainability. For example, a meta-study from Deutsche Bank and the University of Hamburg showed that 90% of 2,200 individual ESG studies show a neutral or positive link between good ESG practices and corporate financial performance, with a large majority of positive findings across regions. In all, this study showed that 38% of studies in developed markets showed a positive link between ESG and financial performance.
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Another headwind to further ESG integration is concern about the quality of data on companies’ sustainability practices. More investors are relying on third-party sustainability ratings frameworks that are based largely on corporate disclosures. But because these ratings are largely disclosure-driven, with less emphasis on corporate behavior and forward-looking strategy, average ESG scores tend to skew strongly toward larger companies with an inherently backward-looking bias. In addition to being market-cap biased, ESG ratings tend to skew more favorably toward regions where corporate sustainability reporting is more common, such as Europe.
ESG ratings can be helpful, but they only tell part of the story. It’s important to use them more as a starting point for developing one’s own view of a company’s sustainability profile.
This is a major part of our value proposition as an active manager, and we deliver on this by doing intensive bottom-up analysis. Our active approach involves sending our analysts around the world to meet companies and talk with their stakeholders.
There are small-cap companies that aren’t reporting or producing sustainability reports, but are actually doing great things to create compelling investment opportunities when viewed through the lens of blended value.
In addition, some enhanced techniques using big data and artificial intelligence can sort through the higher-frequency data points and help offset the fundamental limitations of traditional ESG rating systems. We see potential applications in both quantitative and fundamental research.
Integrating ESG in an authentic manner that is aligned with one’s philosophy and process is difficult. It can’t be achieved through a simple overlay or siloed approach.
1The term “blended value” was developed by impact-investing thought leader and author Jed Emerson.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of William Blair Investment Management or TEXPERS.
Blake Pontius is director of sustainable investing and a global portfolio specialist at William Blair Investment Management. In this role, he coordinates the firm’s integration of environmental, social and governance factors in its investment processes and provides analytical support to portfolio managers on the global equity team. He is also responsible for communicating investment strategy and portfolio positioning to clients, consultants, and prospects.