Finding ourselves in the ESG avocado

I took the role of Head of Sustainability for North America in large part because considering sustainability factors as a component of proper investing appears to me both necessary and unobjectionable. This applies to both ESG integration into investment decisions as well as active ownership. The former can be summarized as “Would you like your portfolio manager to take into account all of the potential financially material risks and opportunities that may face a company, or do you prefer that s/he ignore some of them?” And the latter sounds like “Would you like your portfolio manager to work with investee companies to seek improvement in their policies and outcomes, or do you prefer that s/he just watch from the sidelines instead?”

While the answers to the questions above may seem self-evident to me, the reality is that there is still significant skepticism surrounding sustainability. This is partly because while there is a lot of discussion in this area, there is also still a shortage of clarity around what sustainability means or what investment firms are doing in practice. ESG, at least in name, seems to be everywhere now and coming from asset managers it can sometimes feel either slickly opportunistic or willfully naïve. It’s easy to have some ESG fatigue, especially when sufficient substance to justify all this attention is often lacking.

That is why it is critical to explain why we, as investors, see the need for integrating ESG into our work, and have done so broadly across the strategies we manage. For our part, we would have taken that step even if we had never received questions from our clients or seen action from some of our global regulators. There are three reasons for this. First, there are risks. The trends in consumer and society sentiment around how companies treat their workers, how they pay taxes, what impact they have on the environment and so on, are becoming increasingly entrenched in policy and regulation. Ignoring this could risk that our clients are invested in companies that could face adverse financial consequences associated with these trends and regulations. Second, there are opportunities; for almost any problem, there could be money to be made in a solution. Examples include carbon capture technologies and nature-based solutions for climate mitigation. And third, impact does matter. No returns are made in a vacuum; they have externalities – positive and negative. Even if the company or investor is not currently bearing the cost of the negative externality, they may have to in the future. For example, think about rising carbon prices, minimum tax or wage legislation or sugar or plastics taxes. It is therefore critical to understand the impact we have so that we can anticipate it before it is reflected in the financial condition of our investee companies. Finally, underpinning all of this is active ownership. It is not just about selecting the right investments and understanding them, it is also about what you do with them when you hold them. If we can engage with companies as investors and guide them to improve what they do and potentially help lead to better outcomes and returns, then we had better be doing it. So, all of this is really very pragmatic and practical, in our view: if we integrate ESG considerations into our investment decisions, we believe we get more durable value for our clients. Period.

It is also worth noting that we do not define ESG as a set factor like Large Cap or Growth which necessitates investment in a specific investment universe or a certain type of company. While there are Sustainable and Impact funds which use certain criteria to target a preferred universe or type of company, we believe ESG integration is better seen as a lens through which all investments can be viewed, across market cap, geography, style, or sector/industry.

However, there can still be a lot of confusion about what ESG refers to, so we must be very clear about what we mean. The ESG “avocado” (see Figure 1), helps us to map out for clients what we are doing for them and where their investments “sit.” It should also be helpful to US clients that the new SEC proposal around ESG Strategy Disclosure for Funds and Advisers uses three similar categories.

Broadly, the strategies we manage across our AUM are ESG Integrated, which simply means that the portfolio managers are taking financially material ESG factors into consideration as a part of their full investment analysis. That doesn’t by itself mean that there are necessarily exclusions. It doesn’t mean that ESG factors are the most important consideration or are driving the decisions. It just means that all the relevant risks and opportunities are being factored in. And it does mean that the portfolio managers are actively engaging with the companies they are invested in, in order to encourage positive change. This must be understood as distinct from either our Sustainable or Impact strategies, which are driven by client demand, based on their interest in either promoting ESG characteristics in the investment criteria (including exclusions) or having specific ESG objectives, or indeed actually targeting specific, measurable environmental or social benefits that may sit alongside the return objective. While this is not for everyone, there are clients who want it, and we are committed to providing investment opportunities to those clients that are aligned with their values and objectives. However, even outside of those Sustainable or Impact strategies, we are deeply committed to the level (or avocado “layer”) of ESG integration which includes analysis of financially material factors and active ownership, engagement and voting. This is what we offer broadly across our strategies since we feel it is necessary from an investment standpoint, in order to deliver the performance our clients expect from us. This is where most of our US clients are in our “avocado,” when it comes to their investments in our strategies.

Broadly across investment desks, our portfolio managers and analysts take an investment-led approach to ESG integration, with the objective of managing risk or enhancing potential returns. While they do look for opportunities to reduce uncompensated environmental and social risk exposures, this is not approached as a divestment exercise, but rather as a way of seeking to identify companies that are successfully navigating environmental and social change, as well as companies that can address change in various industries through innovation. We believe this, combined with active ownership and meaningful engagement, allows us to build more robust portfolios. Recent examples from some of our investment desks of alpha generated from ESG integration include underweights to Chinese companies last year and Russian companies this year, on the basis of accounting for social and political risks.

Another example this year to date is exposure in a number of our strategies to energy companies that have made net zero commitments and are decreasing their carbon intensity and increasing their investment in renewable products and carbon capture technologies. In other words, we take an approach that is not focused on divesting energy exposure, but rather on tilting towards energy companies that we see as evolving successfully and developing products that enable that evolution. This is because we believe that, in most cases, the companies that will have the biggest influence on the success of decarbonization are not small, unknown start-ups; they are the large companies that are ahead of the curve on these global trends and that will therefore likely outperform.

In all these cases, an integration of ESG analysis was a direct contributor to positioning in our portfolios and additive to performance; this is what we mean by an investment-led approach.

As noted, these efforts are also complemented by a commitment to engagement with companies, an undertaking that is now required of all of our investors, on social issues like human rights, human capital management and diversity, and on environmental issues around climate and natural capital/biodiversity, as well as on governance, all of which are laid out as the key themes in our firm’s active ownership Blueprint. In this process, our investors seek to identify issues that we believe are risks that an investee company could mitigate in order to ensure more durable returns in the future. We increasingly have the ability (with improved data, knowledge and access) to become engaged with management and encourage improvement in their company policies. Investee companies, in turn, are becoming more receptive to constructive engagement and this alignment between corporates and asset owners/managers is an opportunity that we believe we need to take full advantage of as part of our ESG integration efforts for the benefit of our clients. And this is why our ESG “avocado” is wrapped in its dark green active ownership skin.

While we may never be able to please all skeptics, we do hope to help many clients and prospects take their first steps in the sustainability journey by demonstrating that we use tools and processes like integration and active ownership with the aim of improving risk-adjusted returns rather than as a sacrifice or trade-off of those returns. We will know we have succeeded when more of our clients recognize and indeed expect these efforts as integral components of good investing, which are therefore both necessary and unobjectionable.