When ESG Priorities Collide
Between a rock and a hard place lies a straw.
Earlier this year, a handful of food-service companies in the US and Europe announced they would phase out single-use plastic straws in an effort to reduce non-recyclable waste. Environmentalists hailed plastic straw bans as a good step toward combating ocean pollution ... but the tide soon turned, so to speak, as disability advocates made their voices heard. They noted that some disabled consumers rely on plastic straws to drink beverages and prefer them to straws made of other materials, which they say don't work as well. In trying to support one popular cause (environmental sustainability), retailers ended up accidentally running afoul of another (disability inclusion).
It's a conundrum not unlike the ones facing investment managers every day. Like retailers, investment managers live in a world where concerns about the environment, diversity and other causes are figuring more and more into key decisions. In investing, environmental, social and governance (ESG) issues are more prominent than ever, as a growing body of research demonstrates that strong ESG performance is associated with better operating performance, better stock performance and lower cost of capital.1 For investment managers and companies alike, making what many would deem "virtuous" choices is actually beneficial to improving financial results.
But what happens when virtuous priorities collide? Investment managers have their own straw-like examples, though they rarely make headlines. Imagine, for instance, an ESG-minded investment manager reviewing whether to add an energy company to her client's portfolio. The energy company is involved in a number of renewable energy projects, such as solar panel installations and wind power farms, but it also continues to maintain a sizeable carbon footprint thanks to a segment of its business that revolves around fossil fuels. Should the manager invest in a company with a seemingly conflicted approach to environmental sustainability?
Making such a decision isn't easy, but the good news is that experienced investment managers have had plenty of practice balancing conflicting goals, long before ESG entered the picture. "Even without ESG, there are already lots of competing investment objectives that we have to deal with," explains Jenn Bender, the director of research for the Global Equity Beta Solutions team at State Street Global Advisors. "Some securities you may want to own to improve return might increase your risk quite a bit or might increase your transaction costs. We're always trying to maximize return while minimizing risk and transaction costs."
The range of approaches to ESG integration highlights the fact that ESG investing remains largely uncharted territory.
At State Street Global Advisors, investment managers use technology to help meet those objectives. They've designed proprietary algorithms to balance competing goals as they build portfolios. But before an algorithm can provide an answer, it needs human input. Investment professionals provide data on a portfolio's specific investment criteria, such as currency and liquidity constraints, in addition to ESG goals, to guide an algorithm. "We have to tell it what's more important, or whether they're all equally important," Bender says. "Those are the kinds of modeling decisions that we bring to the table."
The bottom line is that whether an investment manager chooses the hypothetical energy company in our example will depend on various characteristics of the company — many of which may be unconnected to ESG — and how those characteristics fit with the portfolio owner's objectives and existing investment mix. Being a large carbon emitter wouldn't necessarily disqualify a company from inclusion, nor would a commitment to renewable energy sources automatically make it a shoo-in.
Also critical to the investment manager's decision? Exactly how she's going about integrating ESG factors in the first place. Bender notes that portfolio-building strategies that prioritize ESG performance are varied in their approach. "It all goes back to what the investor wants," she says. "Does the investor want an equity portfolio that will deliver close to the long-run equity premiums, gauged by a broad benchmark, but have ESG integrated into that? Another objective might be, 'Look, we want to harness the premia from certain fundamental factors like value or growth or momentum and integrate ESG.' Another investment objective might be, 'We want to de-risk and keep ESG,' or, 'We want to beat the benchmark through active stock selection and keep ESG.'"
The range of approaches on ESG integration highlights the fact that ESG investing remains largely uncharted territory; full of complex decisions and between-a-rock-and-a-hard-place scenarios that give the plastic straw conundrum a run for its money.
"There's not a whole lot of empirical settings you can point to because the ESG data is so new, and because best practices around ESG in investing haven't evolved yet," Bender says. "We are setting those best practices as we speak."
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Investing involves risk including the risk of loss of principal. You should consult your tax and financial advisor. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The whole or any part of this report may not be reproduced, copied or transmitted, or any of its contents disclosed to third parties without State Street's express written consent.
The views expressed in this material are the views of Todd Bridges and Jenn Bender through the period ending September 2018 and are subject to change based on market and other conditions.
Bender, J., Xiaole, S., & Wang, T. (2017, December 05). Thematic Indexing, Meet Smart Beta! Merging ESG into Factor Portfolios. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3080355
Todd is a Vice President on the Global Equity Beta Solutions team, where he conducts ESG Research and Strategy Development.