In the first part of our discussion of Sustainable Investing, we looked at key building blocks and summarized strategies for building them into a portfolio. Now we’d like to dig a little deeper into sustainable investing.
A Standard Challenge
First the promising news: As we touched on before, there are ways to factor in Environmental, Social and Governance (ESG) ratings already. We continue to explore how impact investing (more direct involvement in corporate governance) can lead to improved outcomes for all concerned. On both fronts, we are optimistic that evidence-based ESG investing can grow increasingly relevant as it matures and melds into our existing best practices. That said, we face a challenge in this still-nascent field: Strong, time-tested company reporting standards remain a work in progress.
For example, the study discussed in “Why and How Investors Use ESG Information” suggests that one of the biggest decision-making challenges is “the lack of comparability of reported information across firms.” The report also notes, “qualitative comments confirm that a lack of standardization and quantification are the main obstacles to ESG data integration.”
To be fair, strong company reporting standards are a challenge. But it can be especially daunting when an approach is relatively new and advancing faster than the rigor of proper academic analysis requires. Let’s explore three of the “standard” growing pains sustainable investing faces: building robust benchmarks, gathering consistent data, and cultivating solid research.
Building Robust Benchmarks
As we mentioned, many have been turning to ESG ratings to “score” various organizations’ sustainable practices. Just as we have standard benchmarks/indexes for other purposes (such as tracking US large companies, global bonds, or emerging market real estate), providers have responded to the burgeoning interest in ESG ratings by offering a growing collection of ESG benchmarks for public consumption. Established providers include MSCI, Bloomberg, and Thomson Reuters. There also is a plethora of newcomers, each offering its own approach and perspective.
Given the assortment, one company’s ESG data may receive widely different “thumbs up” or “thumbs down” scores, depending on who is doing the rating, and to what aim. For example, this Wall Street Journal article explains: “The real complexity comes in the question of what counts as ‘good.’” The article shows that the global head of ESG research at MSCI says the aim of its ratings is to highlight financially relevant ESG risks, but the FTSE, by contrast, is more focused on helping investors change corporate behavior.
It’s not necessarily bad or wrong for different rating companies to rank the same data in various ways. Their varied opinions contribute to efficient market pricing. But it does mean that we want to understand the differences among various ratings, and what they signify, so as not to inadvertently compare “apple” results with “orange” benchmarks.
Developing Data Standards
Rating agencies, fund managers, and investors face a common challenge: Some of the data used to score a company’s ESG activities may be more or less dependable to begin with. Some standards exist for how and what a company should report with respect to its ESG practices. For example, in “Sustainable Investing: From Niche to Normal,” a CDP — Carbon Disclosure Project – hopes to encourage companies to report their greenhouse gas emissions, as the UK requires all its listed companies to do. And there is an investor-driven organization of 250 members that voluntarily report on the ESG performance of real estate portfolios.
There are many other examples, and growing demand may further accelerate the movement toward more standardized reporting. But for now, ESG reporting remains mostly a voluntary endeavor. Cerulli Associates in 2018 surveyed more than 400 advisors and asset managers and reported that the vast majority felt challenged by “the fact that companies provide limited or selective information about their efforts to meet environmental, social and governance standards,” and that “the information they are given is too subjective.”
Also, “ESG” is not one thing – it’s three. Not surprisingly, environmental, social and governance standards are developing at different rates, based on various demands and practicalities. As described in the Sustainable Investing report, many environmental metrics are becoming increasingly standardized, but investors should be more cautious about social metrics, which often represent highly qualitative issues. Some also wish to incorporate or avoid other values-based characteristics in their investments – such as religious or political affiliations. For these, quantifiable reporting standards may take even longer to create.
Cultivating Research Standards
So how do we balance the desire to invest “ethically” with our fiduciary duty to advise according to the highest financial interests? The goal is simple enough: We’d like to provide both. Existing studies and practical applications suggest we can. That said, we’re still early in the process. By definition, it takes years, if not decades, to determine whether evidence-based theories test out in reality – through all markets, both here and abroad, and across all asset classes. The reality is, evidence-based sustainable investing is too new to have experienced this optimal degree of due diligence.
For example, consider “sin” stocks versus ethical investments. Have they actually delivered better returns, and under what conditions, and with what risks? We continue to see debates that contribute to our understanding of these important issues. Given the level of investor interest, many are working to resolve the various riddles and create a body of evidence to achieve a high standard of excellence.
At the same time, we know that our clients do not want to wait decades to invest more sustainably. In fact, many are unwilling to invest otherwise. We deserve solid advice on how to make the most of the existing sustainable investment solutions, come what may as the future unfolds. We will continue to research and inform with the latest findings.