About $23 trillion in total global assets was professionally managed under environmental, social, and governance (ESG) strategies in 2016, according to the Global Sustainable Investment Alliance.
That figure represented a 25% increase over 2014. Assuming that stampede into ESG has maintained a similar pace into 2018, the total AUM of global ESG strategies could approach or even exceed $30 trillion by year’s end.
One of the leaders of this charge is Hermes Investment Management. A drafting signatory of the Principles for Responsible Investment (PRI) at the United Nations in 2005, Hermes has long been a pioneer of ESG investing and continues to be an innovator in the space.
To see how ESG is influencing investment, risk management, and company selection, we spoke with Hermes’s head of sustainable investing, Andrew Parry, for his take. A member of Hermes Strategy Group, Parry believes ESG represents a new conceptual paradigm in investing that can be implemented across asset classes and investment strategies to improve risk-adjusted returns.
CFA Institute: How do you approach ESG investing at Hermes?
Andrew Parry: Hermes has been in the asset management business since 1983, originally as the in-house pension fund manager in the UK to the British Telecom and Royal Mail pension schemes, and eventually as a manager of third-party assets. We still have the BT pension schemes as major clients, but now with a diversified revenue stream.
The importance of our origin as an in-house pension fund manager for BT and Royal Mail is that it has imbued us with a long-term perspective, a view we still hold today. From the outset, we have embedded responsible investing in our mission statement. For us “responsible investing” means recognizing the influence that we can exercise on the environment and society at large, and the importance of good stewardship, while providing attractive risk-adjusted returns for our investors.
We are actively engaged in public policy advocacy issues relating to ESG since 2004. We now have US$40 billion under management and nearly half a trillion US$ under advice. We provide stewardship services for a broad range of global asset owners, mainly pension funds but increasingly private wealth clients and other asset managers, where we do voting, engagement, and stewardship around ESG risk factors. We have a high degree of awareness of ESG in our investment products and, over time, we have gathered evidence that integrating ESG certainly does not harm and, in fact, is additive to value generation.
How do you integrate ESG into your investment process?
Our team of global equity research analysts takes ESG inputs from a variety of data sources: MSCI, Trucost, Factset, Bloomberg. They then integrate the data into a QESG dashboard, which contains roughly 30 individual factors under Environment (“E”), Sustainability (“S”), and Governance (“G”), respectively. They rank each of those factors within the universe against an industry grouping and a global index to obtain an overall ESG score.
A key feature of our QESG dashboard scoring system is that it provides an indication of ESG momentum, the change in the ESG ranking. You can have a company with a great ESG score but that score may be deteriorating: This can be a very relevant signal for us in terms of whether we want to maintain, enhance, or exit from an investment. We also drill down to understand the qualitative factors in our system and their risk implications. All these considerations are then consolidated to achieve a final ESG score, the investment’s “alpha” score.
From an overall asset management perspective, we look to integrate ESG not only in our equity strategies, but also across asset classes, such as in the credit markets, infrastructure, and real estate. If you are a credit investor, cash flow security and risk considerations are perhaps even more important than they are in equities.
How do you engage with your portfolio companies?
Engagement is very important for us as a way to add value to our portfolio companies. In a strategy with an “active” component, we look to determine whether we can have an impact to change the score and improve each of the key ESG factors for our portfolio companies. We ask ourselves: Can it be done through engagement? Are the ESG factors systemic and perhaps not susceptible to change? We also consider the sustainability of a company’s franchise. Which process should the company follow to incorporate ESG goals into its business strategy? Is there a suitable individual or team within the company to lead this effort (i.e., CEO, finance director, or other)?
Credit strategies present a great opportunity for ESG engagement. In the current markets, there are many more companies that are raising debt versus companies that are raising equity capital. You can engage a company to pursue ESG improvements at the point of new debt issuance, and then pursue ongoing engagement with the company to improve the security of your cash flows.
How is your role in providing ESG ratings different from that of ESG rating agencies?
It is very different in that we are not defining what “best” looks like. We are not stating if a company is “good” or “bad.” We expect that each company will have a complex series of positive and negative ESG metrics.
Rather, we focus on how companies can improve their ESG ranking and how we can encourage a shift to a more positive environment — the “ESG momentum.” We have 47 investment and advisory clients around the world: Every two years we agree on an engagement plan around areas in which they have a particular interest. For instance, they may want to focus on issues such as the use of child labor in the supply chain, the amount of CO2 emissions, diversity in the workforce, and so on.
We typically engage with over 400 companies on behalf of our clients to support the desired ESG changes. Our ESG ratings help us determine how companies are responding to our ESG engagement work. Our focus is on changing the direction of travel. If you are a coal miner, you operate in a business that is likely to generate ESG issues by its own nature, and you face an ESG “barrier to exit.” We are not about excluding whole lines of business from our analysis. We consider the social and environmental aspects in all industries, and their impact on long-term sustainability. We look for companies that add value for our clients on a risk-adjusted basis, and companies that are working to improve their ESG ratings. I would rather have a company that scores 16 and is on its way to 18 rather than one that scores 19 and is heading towards 17.
Also, even in our systematic strategies, we add an overlay of active selection, whereby the portfolio manager has the authority to modify investment decisions if there is a perception that the input data do not reflect the current status of the company’s fundamentals.
How do you approach ESG in private equity and real estate?
ESG considerations are relevant in private as well as in the public markets. As a general partner in a private equity fund, you have even more influence on our portfolio companies: You can have a seat on the board, with great opportunities to improve outcomes and behaviors.
We are also seeing good opportunities for ESG engagement in the real estate industry. For instance, we are now working on a 64-acre development at King’s Cross site in London, where environmental and social issues are a key part of the investment strategy of our real estate team. Among others, we are considering how to enhance the environment for people living in the area, how can we bring in more artisan shops perhaps, and social housing alongside new offices and more expensive housing. We like to think of engagement as reinforcing mechanism to ensure that, in addition to the financial characteristic of an investment, we are also aware of its role in creating a stable and sustainable system.
How relevant is it for managers that don’t specialize in ESG strategies to consider the implications of ESG factors on their portfolio?
It used to be that ESG was isolated in ESG-specific strategies. For a long time, we have been working to shift away from this approach to make sure that all our managers have ESG awareness. I do think that this is a general trend in the asset management industry at the moment. If your ESG approach works in your mid-cap equities, why shouldn’t it be working in other strategies? Most companies can be analyzed in terms of ESG factors. We have had very strong results in certain emerging markets, particularly in Asia.
Managers are starting to understand that ESG inputs can contribute to the valuation of the business in any strategy. I can see a trend in the industry to shift the focus from launching ESG products to have all products classified in terms of ESG. We all want sustainable franchises in our businesses, sustainable cash flows, enduring governance. Investment managers and companies alike are recognizing that there is an operating benefit, not just a rating benefit, in ESG.
How do you evaluate investment performance in your ESG portfolios and do you think that ESG factors could be a systematic source of outperformance?
Our main role is to be good investment managers. Ultimately, we evaluate our performance by comparing our results to that of broad market indices, similarly to any other manager. We recognize that we have a fiduciary responsibility to deliver attractive risk-adjusted long-term returns to our shareholders.
In terms of indexing and benchmark comparison, we are an active manager and we are paid to be different from the index, even in our systematic portfolios. While we are aware of ESG indices, we don’t typically use them as benchmarks. If you benchmark yourself against an ESG index, you have already accepted that the published reference index has the right assessment of what a “good” company is in terms of ESG, which we don’t necessarily share.
Do you think that the perception is shifting with regards to ESG’s ability to generate outperformance? If yes, what are the major implications of those changes?
Up to a few years ago, there was a widespread perception that ESG came at a cost. These days, I sometimes feel that we are moving too far in the opposite direction, namely that we may conclude that ESG automatically produces improved results. We are appending the ESG adjective to all sorts of activities and products: sustainable shoes, sustainable coffee, even sustainable tobacco.
It is critical for investors to continue to be aware that in order to generate alpha you need to have good execution. The market is competitive and there is a danger that people can crowd into the same trades, trades that have the “right” characteristics. Investing in a company that is tagged as “good” is not necessarily going to generate improved results. ESG “momentum” is a much more relevant indicator.
Having said that, there is definitely a growing belief that asset managers should consider ESG factors as part of their investment approach more broadly across strategies and asset classes. For me, this involves taking a longer-term perspective to investing, and targeting a low turnover (20% is not unusual, particularly in the developed market where our ownership is often four to five years). Time is the last arbitrage. Investing, in a way, is like running a business: We are really making decisions about the next five to 10 years. As investors, we want to think strategically and harmonize our approach to that of the businesses in which we invest.
You have pursued your studies in mathematics, but you are talking a lot about quality: quality of data, qualitative disclosures, qualitative judgment in evaluating ESG factors. What do you see as some of the key risks in relying on data sourced and processed using artificial intelligence (AI)?
I love the mathematics behind AI: Some of the AI techniques can be very good at extracting data from new sources and processing them in ways that can reveal fundamental new insights about a company. Still, we need to be aware that a level of quality control on the input data and on the results of the processing phase is needed. There is a lot of anecdotal data out there, and most of the data we process is unaudited and can be subject to manipulation.
My math degree has been very useful in helping me maintain a certain level of skepticism about how data is used. In a model, I look to see the disclosures about the key assumptions, its scope, and the source of the input data. Not long ago, we did not have a cash flow statement. We are now moving towards greater disclosures also as they apply to modeling and input data.
In terms of ESG data, I have noticed that quite a few companies that may fall into a negative ESG perception, such as gambling or tobacco, suddenly have become very good at disclosing ESG data, and that sometimes it is the “greenest” companies that have been laggards in disclosure. As a result, some of the companies that you would not typically associate with ESG based on the very nature of their business, may end up getting very high ESG scores. That can be a challenge for an ESG analyst. Companies have become quite savvy at recognizing how some of the more established ESG rating systems work. If you present very thorough and detailed disclosures, you may end up getting a high ESG score in certain areas, independently of what the data means in terms of ESG risk.
In a way, investing is still a social science. We should always be aware that numbers still leave a broad scope for interpretation, and not take them for granted just because they came out of a sophisticated algorithm. Digging into search engines is still an imperfect art.
It’s important for us to remember that at the end of every investment and every company, there are people, workers, and local communities.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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