ESG Analysis Might Be Popular, but Not Everyone’s an Expert

One of the main reasons many institutional investors have taken a shine to socially responsible investing (SRI) is the perception that such strategies help alleviate risk.

Although SRI specialists and some mainstream investment management firms have incorporated environmental, social and governance (ESG) criteria into their analysis for some time, the fact that others are rushing to meet investor demand means portfolio managers are implementing ESG analysis at a higher rate than ever, often without formal training.

“It is a mistake to treat ESG considerations in investing as an obscure art that you can somehow master without being able to explain it,” says Usman Hayat, London-based director of Islamic finance and ESG at the nonprofit CFA Institute. “If reading a few articles and attending a few conferences do not make you an expert in investing, then the same cannot make you an expert at considering ESG issues in investing.”

The conventional wisdom says that demand from investors has been driving the boom in SRI. Indeed, 64 percent of asset managers polled in a survey released late last year by Boston-based research firm Cerulli Associates reported that they believe it will be “very important” for managers to offer ESG capabilities in the next few years — simply to compete in the marketplace.

Of the investment professionals responding to the Cerulli survey, and another done by the CFA Institute, nearly 75 percent said they consider ESG factors in their analysis, with risk management cited as the top reason for doing so. In the same CFA Institute poll of portfolio managers and research analysts, however, only 53 percent said employees at their firms had received training on how to consider ESG issues in investment decisions. Of those who did receive training, the majority said that was done via miscellaneous sources such as research papers and conferences; slightly more than half learned on the job, and a smaller proportion reported having taken a structured course, either in person (31 percent) or online (13 percent).

The CFA Institute, which included the poll results in ESG Issues in Investing: A Guide for Investment Professionals , an October report that Hayat co-wrote, now offers free, in-depth training in ESG analysis via a 12-part online course.

A deep understanding of the how-to is clearly important, education proponents argue, especially if the investor’s primary motivation for SRI investing is to reduce risk. A great amount of research points to companies with high ESG ratings as also having lower risk ratios, but if the analysis isn’t done properly — or taken seriously — the investor might wind up being unpleasantly surprised.

One example that has become the subject of hindsight-is-20/20 banter is the Volkswagen emissions scandal. The German carmaker had long touted its sustainability record and was viewed by many as environmentally progressive compared with its peers, but VW had been the subject of governance questions for years. A 2009 survey by IVOX, a subsidiary of Glass Lewis, a San Francisco–based company that advises shareholders on voting at annual meetings, suggested that of any German blue-chip, VW had “by far” the worst governance structures.

“Volkswagen did have some good ESG headline scores, but drilling down into the details, one could already observe several controversies and red flags in the data of several ESG data providers that indicated issues at the company, and hence an increased risk of future adverse events materializing,” says Jeroen Bos, head of equity specialties at the Netherlands’ NN Investment Partners (formerly ING Investment Management). “In my view, proper integration of ESG factors in the investment analysis, with a focus on materiality, could be a very helpful tool to prevent having exposure to these types of events.”

In a recent blog, the CFA Institute’s Hayat pointed not only to VW but also to the cases of worker strikes at South African mining company Lonmin and the BP oil spill. He argues that in 2012 investors realized after the fact that Lonmin was carrying considerable social risk, when the company experienced a breakdown in its relationship with its workforce. Similarly, with BP’s 2010 oil spill in the Gulf of Mexico, investors realized after the fact that the company had a considerably worse health and safety record than its peer group and was carrying significant environmental risk.

“Was it possible to better assess these particular risks before the fact using ESG analysis to complement traditional financial analysis?” he wrote. “That’s arguably a subjective debate. What is, however, not subjective in such cases is that there is often publicly available ESG information that could have helped investors better manage these risks.”