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What is ESG investing and why is it important?

What is ESG investing and why is it important?

Environmental, social and governance (ESG) investing is a form of investing which involves assessing companies based on their  environmental, social and governance characteristics, as well as more traditional metrics such as profitability or market opportunity. Some might argue this is not new, as factors such as reputational risk and regulatory developments have always been part of fundamental analysis and risk assessment. However, the ESG approach involves a more systematic consideration of specific issues throughout the entire investment process.

Below are some examples of ESG factors:

  • Environmental – climate change/carbon emissions and toxic emissions/waste
  • Social – health and safety of employees, data protection/privacy and community relations
  • Governance – diversity, compensation and business ethics

ESG managers also go beyond integrating their defined factors into their security selection process and actively support their principles through shareholder engagement. Such fund managers will, for example, communicate directly with the company’s senior management to improve ESG practises or exercise their voting rights.

We at Defaqto, along with many other people, have seen a growing interest and an increasing number of fund launches in the area of ESG investing over the last few years.

We see no sign of this abating, for the following two reasons in particular:

  • Empirical research into ESG investing has shown evidence of a positive effect on returns, or at least no performance penalty. Companies which behave responsibly and incorporate ESG principles into their business are usually better custodians of capital and in turn provide higher long-term returns.
  • MIFID II rules will soon require advisers to ask clients about their ESG preferences and take these into account when assessing the range of financial products to be recommended to them – fund and portfolio recommendations will need to match each client’s individual ESG preferences.

As a result of the second point, advisers will need access to ESG data and fund research to fulfil their requirements. However, the amount and quality of ESG-related information reported by companies still varies considerably. Also, in the case of the fund manager, how ESG factors are implemented in the investment process can vary – having ESG in the fund title or mandate doesn’t guarantee a robust process! Therefore, some reasonably detailed research will be needed before the adviser can recommend any ESG funds to their clients.

Several firms now provide research and ratings for funds based on their ESG characteristics and integration of ESG factors, such as the commitment across the manager’s firm to ESG issues or whether ESG views are translated into portfolio positions.

This can be quantitative; for example, aggregating company-level ESG data and scores for each fund and then normalising the totals to make them comparable across industry groups to derive an ESG rating for the fund. Or it can be qualitative, where the fund manager and other key individuals are interviewed to ascertain their ESG approach, both at firm and fund level.

At Defaqto, we have been working on producing new ESG reviews for funds. The information for all of this is obtained through a detailed meeting with the fund manager as well as sending them an ESG-related questionnaire to complete before the meeting. We expect to launch these ESG Reviews in Q1 2020 and they will be accessible to advisers through our Engage software.

Patrick Norwood

Insight Analyst Defaqto

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