ESG-Integrated Investment Opportunities: Investing for Future Generations
ESG investing has become an intrinsic part of the investment process and consists of rigorous research that addresses non-financial metrics — and certain financial metrics — proven to have an impact on shareholders’ value by influencing revenues, costs, or cost of capital. This assessment is of utmost importance today, as companies generate most of their value from intangible assets when compared to companies 30 or 40 years ago, and even more so than companies in the 1930s, when the foundation of fundamental analysis emerged.
When discussing ESG, it is essential to establish the distinction between what is considered an ESG fund and an impact investing fund. Both are important tools, but they tackle different problems. Impact firms often maximize for impact and therefore are measuring for that. ESG funds are maximizing for profit and integrate ESG into in-depth fundamental analysis; their positive impact is a result of the investment strategy, not the strategy itself. At Richmond Global Compass, we utilize material ESG metrics to provide insights that will generate alpha. Many are rushing to integrate ESG into their existing processes because their clients are demanding it; we built our firm around ESG and the belief that this integration will add to our returns.
One major challenge that ESG investing currently faces is dealing with self-reported, low-quality data. This is much like financial data in the 1930s before accounting standards were implemented. This lack of standardization and confusion around what should be reported has been holding back the evolution of the sustainable finance world, however, initiatives such as the Sustainability Accounting Standards Board (“SASB”) and their materiality framework are steps in the right direction to create a cohesive understanding of what metrics should be published and how these should be presented.
Materiality, a focus shared by both SASB and our Fund, is instrumental for the widespread adoption of ESG investing. A material ESG metric is one that has a proven financial impact, ultimately affecting the shareholder's value. For companies, material ESG metrics affect either revenues, costs, or cost of capital, which not only mitigates risks but also informs sources of business opportunities. For example, food retail companies could add a premium to locally sourced products that are highly demanded by millennial consumers, or a mining company could avoid production disruptions and environmental liabilities by limiting water withdrawal in regions facing droughts.
Professor George Serafeim from Harvard Business School demonstrates in his seminal study "First Evidence of Materiality" that companies that outperform in material ESG generate a 6% annualized alpha compared to companies that underperform in those factors. As materiality is better understood by asset managers, asset owners and the management of companies, the clear advantage of ESG integration will drive its adoption.
Whether or not ESG focused asset managers should adapt their preferences to suit their investors’ values is a question of mandate. In our case, we aim to generate alpha by incorporating ESG but we do not have any specific assets or companies that we are refrained from or obligated to choose; we consider only how the ESG drivers of that particular asset are influencing our investment. Ultimately, we believe that as more investors and companies perceive the value added of ESG, more capital will be driven to investments that will have a positive impact in the world.
ESG investing provides a more complete view of companies and assets and is inherently connected to fundamental investing, therefore it is natural that it has been applied to this strategy and toward equities selection. However, it can be used to assess any asset. For sovereigns, for example, policies to increase women in the workforce will directly affect the country’s productivity level, ultimately impacting bond prices.
Similar to the way financial metrics are utilized today, we believe that in the future all investors will understand the value of incorporating ESG into their investment process. In time, with greater understanding, the decision to implement ESG may be broadly adopted. Investors will then seize this opportunity to drive planetary sustainability through the allocation of global public capital.
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Peter B. Kellner is Founder and Managing Partner of Richmond Global Compass
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