Responsible Investment: The challenge of choosing ESG securities
The terms “responsible investment” (RI) and “ESG investment” have become almost interchangeable, but there are some differences. The ESG acronym refers to the environmental, social and governance criteria themselves, such as greenhouse gas emissions (GHG), or gender diversity. A financial product will be more or less responsible in terms of the importance it assigns to these criteria when choosing the securities it contains.
Most portfolio managers now use ESG data when evaluating a company or a fund, but often in very different ways. “Responsible investment strategies range from simply integrating ESG factors into investment, to a concern for social consequences (called impact investing in the industry) and philanthropy,” explains Mathieu Blais, cofounder and portfolio manager at BeeQuest.
“We prefer to depend on raw data, since this reduces the risk of our being affected by bias in agency scoring.” — Mathieu Blais
A panoply of strategies
Basically, ESG factors are added to the evaluation of risks and returns of a company or a fund. The manager takes them into account, but doesn’t necessarily make them a priority when choosing. Some managers go a step further by using negative screening (excluding certain economic sectors like oil or weapons) or positive screening (including or overweighting some securities as a function of certain EST criteria).
“These approaches are not mutually exclusive,” explains Mathieu Blais. At BeeQuest, we integrate ESG factors when analyzing all companies that we evaluate, according to the elements that are relevant for their activity sector. This allows us to promote the best ESG players, while excluding the companies that don’t respect certain criteria judged to be the minimums by our portfolio managers.”
Social impact investment goes further and involves funds which from the start aim to create positive and measurable impacts on the environment or society. The question of returns is raised afterward. Philanthropy only seeks to have a positive effect without necessarily generating any returns.
“Faced with so many different choices, it’s crucial to understand our client’s RI vision, so as to offer them products that align with their values,” says Mathieu Blais.
Addenda Capital, a firm that manages assets of more than $35 billion, depends on a RI team and takes ESG factors into account in its investment decisions. While it excludes certain sectors, such as controversial weapons (e.g., anti personnel mines), its approach is primarily based on engagement with companies.
“A company is not ESG or non ESG, it has ESG practices that can be improved over time,” explains Réjean Nguyen, director of the RI team at Addenda Capital. “We want to be a factor in the improvement of all companies, so we prefer to use our influence in them instead of excluding them.”
The manager also underlines the importance of completely understanding clients’ values and creating RI products that respond to their expectations. For example, Addenda offers a fund without fossil fuels that includes fixed income products that finance emitters whose social and environmental impacts are positive. It also offers climate transition strategies, which invest in companies that support the transformation to a carbon neutral society.
Separate the wheat from the chaff
Managers still face problems when the time comes to decipher and compare ESG performance data between companies. “A dozen years ago, it was hard to obtain this kind of information,” recalls Réjean Nguyen. “But today, the challenge is to sort through all the information available, to find the most robust and relevant data.”
Over three, five and ten year periods,
the average returns for responsible investment funds
surpassed the average return
in their asset category dans
in Canadian shares and
But the trend inverted last year,
when RI share funds lost more value
han the average in their asset category.
Approximately 25% of Canadian RI funds
outclassed the average return
in their asset category between
the 2021 second quarter
and the 2022 second quarter.
Source: Morningstar data compiled by the Responsible Investment Association.
“We want to be a factor in the improvement of all companies, so we prefer to use our influence in them instead of excluding them.” — Réjean Nguyen
In North America, no regulation requires that extra financial information disclosed by companies be uniform. Some systems have emerged over the years to develop standards, including the Sustainability Accounting Standards Board (SASB) and those created by the Task Force on Climate Related Financial Disclosures (TCFD), but their use is still voluntary..
Creation of the International Sustainability Standards Board (ISSB), announced in November 2021, may improve the situation. This organization, with a regional office in Montreal, aims to provide consistent, harmonized standards for the disclosure of extra financial data related to ESG factors. It is leading an effort to combine several systems, including SASB, TCFD and others.
There seems to be real movement toward the adoption of systems that will provide rigorous data disclosure. “However, we’re still dependent on the willingness of companies to use them or not,” recognizes Carl Pelland, Vice President, Fixed Income and Co Head, Corporate Bonds, at Addenda Capital.
NET SALES OF
RI MUTUAL FUNDS
AND EXCHANGE TRADED FUNDS
(in billions of dollars)
Beyond ESG scores
Harmonization is also increasing with regard to organizations that provide ESG ratings for companies due to the trend toward consolidation. The last few years, for example, saw the merger of Sustainalytics with eight smaller ESG rating agencies; it was later purchased by Morningstar, in 2020. Vigeo Eiris united two major agencies (British and French) before it was acquired by Moody’s in 2019. MSCI, Bloomberg, FTSE Russell and S&P Global also offer heavily used ESG rating services.
Portfolio managers now have access to raw data – such as GHG emissions, water consumption or company governance diversity – as well as to ratings provided by agencies. But the latter may lead to unhappy surprises.
In France, for example, several ESG funds held shares in medical retirement homes giant Orpea, which enjoyed an excellent social score. However, in January 2022 the scandalous practices of the company, which massively mistreated seniors, came to light. The company rapidly crumbled in the stock market.
“We prefer to depend on raw data, since this reduces the risk of our being affected by bias in agency scoring,” explains Mathieu Blais. “This means we can avoid, for example, having a company in one of our funds with a good ESG score that don’t really correspond to our expectations.” The firm uses about 50 measures, ranging from GHG emissions per million dollars revenue to board of directors’ diversity, from worker relations to water use and toxic waste production.
A turbulent period
When you say investment, what you mean is yield. For a long time, the fear that sustainable investments provide a lower long term return than traditional investments was one of the main roadblocks to RI. This concern has retreated in light of many studies that have demonstrated a connection between ESG factors and the solid performance of certain funds.
Since the beginning of 2022, the increase in value of energy in the financial markets and the drop in securities of the major technological companies (highly represented in many ESG funds) has spurred several financial products that are not very taken with ESG criteria. Some ESG funds have even reviewed their policy of excluding the oil sector. Bank of America recently revealed that 6% of European ESG funds now hold investments in Shell, compared to none a year ago.
But Mathieu Blais is not overly concerned. “We believe that medium – and long term yields of companies with good ESG performance or who are working to improve their ESG score will be better than their competitors,” he says.