The argument for ESG integration

A new phenomenon has been emerging in the space of socially responsible investment. It’s the integration of environmental, social and governance (ESG) information into investment processes.

The growing interest in ESG information within the mainstream investment community has meant various ESG factors are entering the vocabulary of mainstream financial analysts and fund managers.

ESG investing was a hot topic recently at Legg Mason’s Global Investment Forum in Toronto.

“Integration of ESG factors is so important, it has to start at the beginning [of portfolio construction]; it is not something you do at the end,” said Andrew J. Goldsmith, vice-president, institutional sales manager, ClearBridge Advisors, a financial services firm in New York. “ESG is becoming more mainstream. People are looking at it because ESG factors can impact portfolio and stock performance.”

In an investor manual, the CFA Institute acknowledges the growing recognition of the need to include the analysis of ESG factors in order for financial professionals to more completely fulfill their duty to act in the best interest of their clients.

It’s thanks to such directives that prudent investors have come to consider ESG issues in their analysis as factors that can have an impact on investment performance. However, much remains to be done to drive the message to a wider audience.

“The value of this integration is not well understood,” says Mathew J. Kiernan, chief executive, Inflection Point Capital Management in Toronto. “One of the reasons it’s not that well understood is because it goes counter to the cognitive biases that have permeated the investment industry for over 30 years.”

Kiernan stresses the need for education as a way to bust the myth that integrating ESG can hurt investment returns. Education, he says, is crucial to ESG integration and urges investors not to take glib dismissals. “They need to be able to stand up to what I call the tyranny of the professionals and ask tough questions and keep probing until they get a decent answer.”

Many ESG issues have historically been areas of concern for shareholders. These include carbon emissions, climate change, renewable energy, ecosystem change, among others. But ESG issues are not limited to the environment. There are a host of social issues—animal welfare, child labour, genetic engineering, political risks—and those related to corporate governance.

Investors seeking a truly thorough understanding of a company or an industry being analyzed must consider the relevance of these issues and their potential for financial impact.

Many of these large ESG issues, says Kiernan, are global and can be proved to have an impact on business profitability. “The case against taking them into account, to me, is just non-existent,” he said.

Goldsmith couldn’t agree more. “If you know about these factors, how can you avoid them? Anything that can materially impact your investment, you want to be looking at,” he said. “You have to be forward thinking and you have to be prepared so you can adjust if you need to.”

Some of the biggest barriers to the integration of ESG in investing are lack of quality ESG data, weak investor capacity, myopic focus and lack of communication of the value of ESG integration and the resultant lack of understanding.

With rapid improvement on all these fronts, arguments against ESG integration are becoming increasingly porous. “Materiality of ESG issues has increased and their integration into financial analysis has become an important performance driver,” said Goldsmith.

Both Goldsmith and Kiernan have made it their mission to draw attention to the need for money managers and financial analysts to interpret and relate ESG factors to a company’s future prospects. The ability to do so, they say, may potentially develop a competitive advantage should others fail to recognize the same risks, or opportunities, related to those factors.