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How Themes Create True Impact
Using them in sustainable investment strategies isn’t uncommon, but how it’s done can make a difference.
From the May 2019 Thought Leadership ESG Report
Shareholders want it and to ensure their future, businesses have to pay attention to it in every move they make – from how their CEO behaves to transparency about processes. It’s sustainable investing, also known as ESG investing, and asset managers are the tip of the spear in evolving strategies that make sense for institutional investors’ need for returns – and to keep their constituencies happy regarding ESG issues.
1 How Themes Create True Impact
Thematic approaches are behind a growing number of sustainable investment strategies, but not all are focused on identifying companies that are purposefully driving solutions to ESG-related challenges. Among the sustainable investment strategies offered by AGF Investments, their thematic strategy helps define and allocate investments to a universe of companies that is genuinely committed to a more sustainable economy – in other words, it’s not enough for a company to show slight improvement in reducing carbon emissions, for example, if its overall mission isn’t pursuing a sustainability related solution. Within its set of themes and sub-themes, AGF scours the investible universe for innovative problem solvers, and other opportunities across the value chains of those innovators. In this conversation, AGF’s Martin Grosskopf (above left), Vice President and Portfolio Manager, Hyewon Kong (center), Associate Portfolio Manager, and Vishal Bané (right), Investment Analyst, share their insights on an approach to sustainable investing that has genuine impact.
Where does a thematic approach fit in the spectrum of sustainable investment strategies?
Martin Grosskopf: It’s important to view the spectrum of sustainable investing through the lens of the investment objective. Most strategies that employ ESG factors use them as an additional layer of risk management – essentially enhancing a conventional approach. Far less common are approaches that use sustainability themes to identify companies that might offer solutions that will be increasingly in favour. We feel a thematic approach has the potential to provide investors with exposure to sustainability issues in a more impactful fashion - while meeting return objectives.
In that context, thematic sustainable investment strategies seem to be gaining momentum. Why is that?
Hyewon Kong: The data in a new report from a global sustainable investment alliance shows that two years ago about $270 billion was allocated to thematic sustainable strategies, and that now it’s above $1 trillion. So thematic strategies are really starting to resonate with investors. Many pension funds, especially in Europe, have traditionally used negative screening as their primary ESG strategy, but more and more they are incorporating the UN sustainable development goals, and those are more aligned with thematic investing.
Grosskopf: Using themes provides a lens that we can use to identify those longer-term opportunities in the marketplace. We’re interested in benefiting from companies that will have a successful model around sustainability in the future, and that’s what our thematic approach does – we look for companies that have the most upside to provide sustainability solutions over time. From that perspective, our thematic approach is quite different from conventional approaches such as using an ESG benchmark.
Opportunities to Benefit from Transition to a Sustainable Economy<
What does the taxonomy of themes look like in your sustainable strategies?
Grosskopf: We break up the sustainable investment universe into four macro themes of water, waste, energy, and healthy living. We have a number of sub-themes under those that we populate by value chain. For example, we look at electric vehicles and autonomous vehicles as one theme, and we populate it across the value chain all the way from mining to battery manufacturers, and into semiconductor companies who do power management, and into the OEMs.
Vishal Bané: Another very interesting sub-theme is food, which addresses quite a few sustainable development goals, such as good health and well-being. So, food has important long-term ESG implications, and from an investment point of view it is an important sector because growth rates for conventional food items – say cheese and meat – have persistently weakened. Globally, consumers are demanding better nutrition and more natural ingredients, and regulatory demands on packaging and labeling continue to evolve. So, identifying companies that are innovating to be part of the transition to meet these demands has thematic and long-term implications for investors. And that includes large cap companies that are desperate to drive the growth over the long term. Sometimes one company addresses multiple themes. For example, if a company is addressing healthy living, safer products, water, and better air quality – and if that aligns with the corporate purpose and mission –that is helping them create better cashflow and higher margins. We see a lot of companies benefiting from these circular drivers.
Can you describe how you assess whether a company is worthy of investment?
Grosskopf: Our focus is entirely on companies that are providing solutions within the themes we’ve mentioned. That’s an important distinction. We aren’t necessarily interested in businesses that are simply doing a better job of managing environmental issues than they once did. We are looking for companies that provide practical solutions that people are benefiting from. We filter the global universe of opportunities to come up with a smaller list, and even that small list is close to 1,000 companies that we think have exposure, in some fashion, to the themes that we’re interested in. That doesn’t mean that they’re immediately attractive for investment, but it provides us with a universe to say, ‘Okay, this company might have 10% exposure regarding renewable energy, but is that going to be an attractive growth driver in the future? Is it going to allow that company to generate higher returns?’ If the company is taking that particular exposure seriously, and applying their capital to it, and growing that within the context of their competitive environment, that’s interesting to us. We’ve been following these things a long, long time, and we have a good handle on who does have exposure in the various areas. Of course, we supplement that with our internal and external research. Increasingly the sell side is becoming engaged on thematics, so they’re drawing out companies that may be interesting, from a thematic standpoint.
Bané: We also talk to company managements. We recently met with the management of one of our portfolio companies – a food company – and we were very impressed with the management’s philosophy of nurturing the trend towards natural, healthier food, where they work with smaller private labels and are prepared to compromise on their short-term pricing power so that all of these smaller players can grow enabling growth of healthier food trend. It’s this holistic approach to innovation, to longer term exposure to the themes we care, that strengthens our conviction regarding the company’s long-term story.
Grosskopf: That’s a good point to raise, because what we tend to find in the market is that investors are still obsessed with whether a company has increased its capital spending on a particular project, and what impact that might have on the very short-term quarterly results. That point of view tends to ignore the three- or four-year return that investment will provide because they are innovating around natural, or more environmentally friendly products or ingredients. Our clients are quite aware of what we’re trying to accomplish, and where we fit in with their overall strategy.
Does a thematic approach have an effect on diversification?
Grosskopf: The portfolio that we have is very diversified across economic sectors, and also within a portfolio context as one of the tools within a toolkit. We have very high active share to conventional benchmarks – easily around 98% active share. So, there’s definite diversification benefits. We have a very off-benchmark sector allocation, but that doesn’t necessarily mean an extreme bias towards one segment of the economy.
Is there a fairly universal embrace by companies of how sustainability issues will impact their success and value in the future, or do some still need convincing?
Kong: I wouldn’t say universal right now, but all companies that are hungry for the growth have to look at where customer demand is heading, and they have to be well positioned to meet it. It’s difficult to not look at sustainability issues when you’re looking at the three- to five-year business strategy – where the business has to innovate and put more capital toward that innovation.
Grosskopf: More and more investors are encouraging companies to address sustainability issues, whether it’s through the business’ strategy or governance framework. Investors want to know what actions companies are taking and what kind of disclosure companies are providing. We will continue to see increased engagement from investors to encourage companies to address sustainability challenges.
Learn more about AGF’s global thematic strategy that helps investors contribute to a more sustainable economy.
2 Key Trends and Inflection Points
Mary Jane McQuillen, Head of Environmental, Social and Governance (ESG) Investment at ClearBridge, is among a small group of portfolio managers in the asset management industry who have been integrating ESG considerations into the equity investment process and raising awareness of the value of sustainability investing for several decades. Mary Jane, or MJ as she is known in ESG circles, is a frequent speaker at institutional investment conferences and sustainability events, and we recently asked her to pinpoint the major issues and trends that are shaping the ESG discussion, and how they inform and impact her firm’s engagement with companies.
Companies are increasingly more predisposed to reach out to us as shareowners, and are clearly interested in having our feedback on everything from executive compensation to supply chain monitoring programs to environmental initiatives. They are also more proactive about meeting us halfway. Instead of our analysts laying out the discussion and seeking responses, management teams solicit our views on relevant ESG topics. Some examples that stand out from the last year are our engagements with Home Depot and Costco, where we provided guidance on best practices for disclosure and reporting.
In the past year we’ve noticed companies seeking ESG guidance from our analysts with greater frequency. Usually this occurs with companies we have owned and engaged with for a long time, such as Trex; in some ways it is a natural result of sustained, meaningful engagement. But in aggregate, we are seeing something of an inflection point. For years as impact investors, we devoted much of our energy to convincing companies that it made shareowner sense for them to discuss these material ESG issues with us. Now many are doing so of their own accord, and picking up where we last left off on topics.
We have seen some progress – although much remains to be done – in companies acknowledging the value of gender diversity in the workplace. On boards of directors, among the C-suites, among management, many of our companies have acknowledged the benefits of gender diversity – and diversity of thinking – and that there is a real struggle for talent. In some cases, companies are beginning the promotion and training of women to create a talent pipeline that will add value down the road. This trend follows conversations between our analysts and our portfolio companies in which, being told at times they were suffering from a lack of available female talent for positions, we’ve asked what companies are doing to create that talent. As we have observed in academic and sell-side quantitative research studies over the past decade, companies with high gender diversity in the workforce and in senior management have delivered higher return on equity, higher return on assets, greater innovation, and lower volatility than companies with low gender diversity.
Carbon continues to be a key issue, and we’ve noticed an overdue awareness that climate risk affects the longevity of all sectors. The establishment of useful, universal standards remains a challenge, as paradigms and terminology shift quickly. A number of years ago, for example, the discussions were around stranded assets. Now the preponderance of different reporting standards and protocols creates a challenge for investors who are paying attention to carbon but are not initiates in reporting-standards discussions. These standards and protocols are thoughtful and useful to certain degrees, but their number and complexity can at times make it difficult for them to act universally as decision drivers. As part of our efforts, in addition to tracking the carbon intensity of our portfolios relative to the respective market benchmarks, we have had initial discussions with our head of investment risk on the importance of keeping our investment teams apprised of exposure to carbon risk across our strategy holdings.
There continues to be a lot of activity on establishing frameworks and standards for ESG reporting and measuring ESG impact, but it is difficult to tell the progress being made. Organizations are working – sometimes together, sometimes apart – to establish protocols for corporations to follow. Corporations, meanwhile, are seeking clarity and actionability not easily found when trying to meet several competing protocols.
The UN’s Sustainable Development Goals (SDGs) offer a way for the private sector to support and address a wide variety of urgent issues that we all know will affect us. However, we do not define our investment process through the SDGs. Instead, we consider the SDGs as a way to provide broader context to the analytical work we do at the individual company level. On top of being valid and effective, this approach of tying our ESG and investment analysis to the underlying targets of the SDGs enables us to do something now.
Our analysts are at the heart of our ESG integration and engagement efforts and our portfolio management teams also play a vital role in discussing ESG issues and the value of considering these issues in company business models and strategy. With the growth of interest in international ESG strategies, we are pleased to have seen progress in formalizing our engagement process with non-U.S. companies. Our international growth and value teams are beginning discussions with companies a little further afield than developed equity markets and these are unusual engagements.
We are also seeing further development of our engagements with small-cap companies. Given the coverage of small-cap companies in ClearBridge portfolios, small-cap engagements are uniquely important. They represent for us the next generation of company engagements, both because as small-caps they do not typically have the coverage larger companies routinely get, and because we have a chance to cultivate relationships and nurture ESG practices at companies from the ground up, like we have done in our discussions with small-cap beverage maker Cott. Ideally, by the time these companies become mid- or large- caps, they will have integrated sustainability practices. We also tend to have more influence with small-cap companies, because they are often looking for guidance as they are still in their adaptive phase.
3 5 Things to Watch
ESG is often spoken of in broad or poorly defined terms, but the authors of the MSCI research report “ESG Trends to Watch: 2019” point out some very specific areas that investors should interest investors and their asset managers. Here are some highlights from this very useful report, which you can download here.
Plastic waste: The number of earnings calls in 2018 that mentioned “plastic waste” increased by 340 percent compared with 2017; and when a natural-language processing technique was used to analyze regulatory filings of the 2,450 constituents of the MSCI USA IMI (as of Dec. 12, 2018), it identified as many as 12 relevant industries potentially exposed to malfeasant rubbish, including agricultural products and office services and supplies. Companies in these sectors will likely be looking for solutions, providing an opening for winners to emerge. Packaging innovations, such as biodegradable, fiber-based renewable packaging, or paper, will likely be further developed to meet the demand from at-risk companies. Already, there has been an uptick in revenue for those companies in the container and packaging industry, with a majority of their revenue made from innovative paper-based packaging solutions.
Regulatory implications for investors: Investors, both asset owners and asset managers, will see escalating demands as regulators ramp up scrutiny to focus on the business of ESG investing. Are institutional investors prepared? Historically, investors generally have welcomed regulatory and quasi-regulatory measures that target issuers, as most of these regulations led to improved data disclosure and transparency on their portfolio companies. In fact, some institutional investors actively seek regulators to weigh in – exemplified by the investor-led efforts in October 2018 to petition the U.S. Securities and Exchange Commission to codify rules on ESG disclosure. And an Ernst & Young survey of 220 global institutional investors found 70 percent wanted regulators to close the gap between what issuers disclose and what investors want in terms of ESG data. Of the more than 170 regulatory or quasi-regulatory measures proposed in 2018, 80 percent of them target institutional investors, not issuers. Whether global investors will support these measures with the same vigor as they did for those imposed on issuers, will likely depend on the regulation – and the investor.
Climate change timeline: In the latest Intergovernmental Panel on Climate Change (IPCC) report on the impacts of global warming, one line among many might give investors pause: “Transition challenges as well as identified trade-offs can be reduced if global emissions peak before 2030 and marked emissions reductions compared to today are already achieved by 2030.” If not, according to the authors of the IPCC report, by 2040, the atmosphere’s temperature will have risen by 2.7 degrees Fahrenheit (1.5 degrees Celsius), inundating coastlines and intensifying drought, poverty and subsequent migration.
It is a finding that converges the time horizons for science and investment – and puts investors on a timeline in which investment allocations made in 2019 will need to, at times, account for an accelerated carbon transition, or accelerated climate-related impacts, before they finish paying out.
The signals revolution: The signals extracted from the ESG data serve not one goal, but rather a panoply. For some investors, the core objective is to identify emerging risks and opportunities and maximize long-term investment returns. For others, it is to identify positive social or environmental impacts, or to match investments with moral values. Not all “ESG ratings” or other rankings labeled as “ESG” aim to achieve the same goal, nor are they equally effective in achieving their particular goal. Different methodologies lead to uncorrelated signals.
Leadership in a time of transparency: The disintegration of walls between the executive suite and markets, governments, and even employees has not just exposed corporate leadership to potential reputational damage – it has also opened investors to new vulnerabilities, as company after company has been shaken by revelations of questionable conduct at best, or illegal activities at worst.
But in 2019, The MSCI authors anticipate investors will stop asking after a scandal, “What did the board know, and when did they know it?” and start asking before a scandal hits, “What are my rights as shareholders?” Investors are starting to insist that, while the parade of CEOs behaving badly may be difficult to predict and avoid, replacing them and cleaning house in the wake of a scandal should not be.
4 The Future of ESG Investing
The following perspective is from Philippe Jordan, President of Capital Fund Management (CFM). For his full insights on ESG investing, go here.
It is clear that ESG data presents as both the biggest impediment to security selection, and (probably) the most commercial opportunity. ESG also fits nicely into the contemporary thinking that traditional indicators could (and should) be augmented with non-traditional data in forming a more holistic view of firm risk and value.
The story of ESG is in large part the story of alternative data, with the unstructured nature of data an opportunity for systematic quant investors being uniquely positioned to uncover and discern between what information could be alpha generating or not. As it stands, managers could either tap into the vast choice of commercially available data sources (while being cognizant of the hazards of this approach), or employ their own skill to scrutinize alternative data. This will, either way, imply a cost to those managers willing to make an investment in this research.
It is, however, clear that many Hedge Funds remain uneager to embark on such an endeavor. A survey by Unigestion reveals that more than half of European-based hedge funds are reluctant about ESG integration, compared to nearly 70% of US-based hedge funds.
A main concern for the lack of interest, is the unease about the quality of data. That data should be improved is a widely agreed objective, advocated by the finance industry and non-governmental organizations. A few organizations are making strides into setting the pace for data quality and comparability. The Task Force on Climate-related Financial Disclosures (TCFD), which helps companies identify climate-related risks, is one. There are, furthermore, various policy initiatives driving an increase in corporate disclosures related to ESG issues. According to the Governance & Accountability Institute, 85% of S&P 500 Companies published some form of sustainability report in 2017. This is up from the 20% that published these types of report in 2011, despite different levels of transparency.
There are claims that machine learning, big data and artificial intelligence are enabling better analysis of ESG data. Despite the benefits and opportunities this presents in a systematic framework, this claim should be met with some caution. Machine learning is not always uniquely positioned to tackle all problems in finance. A recent paper by Arnott et al. highlights one of the “crucial limitations” of machine learning, namely “data availability”, since machine learning applications work best when there exists a vast amount of data. While the amount of data that could pertain to ESG-like issues has increased, one is susceptible to overfitting and finding spurious relationships with data that are not relevant, or material.
Another barrier often cited for ESG investment practices is the limited understanding of the material ESG issues affecting firms. It is likely that firms will allocate more resources and expertise if they are truly committed to ESG investment.
Learn more about the what, why, and decisively, the how of ESG investing from a quant perspective.