ESG and sustainability: Looking beneath the hood

When environmental, social and governance (ESG) funds were in their infancy, a common misconception was that investing responsibly involved some trade-off in terms of performance.

Today there are a plethora of studies available that dispel this myth. In fact, of 200 academic studies on the link between ESG and returns, 88% indicate that companies with strong sustainability practices demonstrate better operational performance, ultimately translating into cash flows. In addition, 80% showed that strong sustainability practices have a positive influence on investment performance[1].

Read more: ESG and financial returns: The academic perspective

However, while it is clear that investment managers who take ESG considerations into account have the potential to outperform, with the vast array of ESG funds now available, it is important to look beneath the hood before investing. Any chosen fund should closely align with an investor’s values, while also supporting their investment goals and desired outcomes.

The active versus passive debate

In selecting a sustainable investment, a first step many investors and their advisers take is to determine whether an active or passive approach is most appropriate.

While interest in passive sustainable investments continues to grow, we believe active management is a demonstrably better approach for investors seeking ESG integration in their investment portfolios.

An active strategy can afford investors a greater degree of control over their investments and allow them to align their views to those of the investment manager, rather than outsourcing everything to an index provider.

While an ESG benchmark may achieve the desired sustainable outcome, it may not be designed to explicitly avoid the uncompensated sources of risk that an active investment manager would seek to avoid.

As an active manager, we use proprietary data to gain a deeper understanding of companies in the investment universe and explicitly target both financial and non-financial outcomes, while constantly overseeing the portfolio’s active risk exposures and taking steps to address these where appropriate.

Identifying sustainable investments: Blending ESG and specific factors

The next step for investors is often to analyse the available product set to find the right alignment with their own individual values and goals.

While some investors have an ethics-based approach to ESG investing, avoiding gambling stocks for example, others approach ESG as a way to evaluate long-term risks and opportunities and invest in companies that contribute positively to issues such as climate change and social justice.

Read more: People power: The post-COVID rise of social impact investing

We find that quality and ESG can often be viewed as different dimensions of the same theme – sustainability. High quality companies not only may deliver superior earnings today but also have the potential to deliver sustainable earnings growth into the future.

Quality analysis

When analysing the quality of a company, we look closely at the way it is managed – how it uses its assets and grows its earnings – but also consider how it is managed as well, including whether it has a diverse board.

Numerous studies have shown that diversity is important to the success of teams, as it fosters alternative viewpoints and challenges ‘group think’. Our research shows that diversity in management boards is linked to better current financial results and also may be an indicator of the ability of a company to protect its future profitability[2].

The second factor AXA IM looks at is volatility, which it could be argued also has a link to a company’s ESG credentials. Young, fast-growing companies, for example, may be more volatile. As they mature, however, businesses may become more stable and are often also able to do more for their employees and society.

There have been many instances of larger businesses using their size and presence to directly influence change. A notable one in recent times was Unilever’s announcement of an initiative to ensure workers across its entire supply chain earn at least a living wage by 2030[3]. The group will also spend $2.4bn globally with suppliers consisting of under-represented groups by 2025.

In seeking out companies that have advantages over their competitors, we believe it is essential to include this type of non-financial consideration in our investment decisions.

With a raft of ESG funds on the market, it is important for investors to do their research and look beneath the hood of responsible investing strategies, to find the ones that suit their aims and objectives best.

Read more: The value of corporate governance in a more sustainable world

 

Sources:

[1] From the stockholder to the stakeholder: How sustainability can drive financial outperformance, University of Oxford and Arabesque Partners, 2015

[2] Diversity: A competitive advantage? AXA IM, 2018.

[3] https://www.unilever.com/news/press-releases/2021/unilever-commits-to-help-build-a-more-inclusive-society.html

Consideration of ESG factors may limit the types and number of investment opportunities available. Under certain market conditions, an ESG integrated portfolio may underperform strategies that do not consider ESG factors. ESG considerations may also affect the portfolio’s relative investment performance depending on whether affected sectors or investments are in or out of favor at any given moment.  In addition, AXA Investment Managers may be unsuccessful in creating a portfolio exhibiting more positive ESG characteristics and/or which assigns more weight to such companies. 

The firm seeks to achieve its clients’ investment objectives primarily through reliance on the modelling of proprietary and 3rd party financial and non-financial data, information, and considerations, the sources, weights, and implementation of which may be subject to change and/or the discretion of the firm regardless of whether described herein or elsewhere. Although many of its investment approaches are driven by bottom-up stock selection akin to that of a traditional fundamental investor, the firm seeks to achieve its clients’ investment objectives primarily in reliance on analytical models. The goal of the firm’s systematic approach is not to replicate a perfect “model” portfolio; instead, like other long-term, fundamentally oriented investors, it seeks to create portfolios possessing ex ante those fundamental and statistically important characteristics reflecting our investment beliefs. The firm’s ability to implement its investment objectives depends on various considerations such as the models’ economic, analytical and mathematical underpinnings, the accurate encapsulation of those principles in a complex computational (including software code) environment, the quality of the models’ data inputs, changes in market conditions, and the successful expression of the models' views into the investment portfolio construction process. Many of these have subjective elements that present the possibility of human error. While the investment process principally relies on models, the firm’s process also incorporates the investment judgment of its portfolio managers who may exercise discretion in attempting to capture the intent of the models, particularly in changing market conditions. The firm’s success in implementing its investment objectives may depend on the ability of portfolio managers and others to interpret and implement the signals generated by the models. The firm has established certain systematic rules and processes for monitoring client portfolios to ensure that they are managed in accordance with their investment objectives, but there is no guarantee that these rules or processes will effectively manage the risks associated with its investment process under all market conditions. While the firm employs controls designed to assure that our models are sound in their development and appropriately adapted, calibrated and configured, analytical error, software development errors, and implementation errors are an inherent risk of complex analytical models and quantitative investment management processes.  These errors may be extremely hard to detect, and some may go undetected for long periods of time or indefinitely. The firm’s controls, including our escalation policies, are designed to ensure that certain types of errors are subject to review once discovered. However, the effect of errors on our investment process and, where relevant, performance (which can be either positive or negative) may not be fully apparent even when discovered. When the firm discovers an investment process error in one of its models, it may in good faith and in accordance with its obligations, decide not to correct the error, to delay correction of an error, or develop other methodology to address the error, if not inconsistent with the client’s interests. Also, the firm generally will not disclose to affected clients investment process errors that are not the result of a contractual or regulatory breach, or that are non-compensable, unless it otherwise determines that information regarding the error is material to its clients.

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