Second Quarter 2018 Update
Written by Jason Hiley
Written by Andrew Hunt
In parts I and II of our series, “An Evidence-Based Approach to Sustainable Investing,” we introduced key building blocks for sustainable investing, and summarized current strategies for building them into your own portfolio. The ground we’ve covered so far may suffice to help you determine if and how you would like to invest more sustainably. But before we wrap, we’d like to dig a little deeper into sustainable investing today.
A Standard Challenge
First the promising news: As we touched on earlier, there already are ways to factor in Environmental, Social and Governance (ESG) ratings – here and now. Practitioners also continue to explore how impact investing (i.e., more direct involvement in corporate governance) may 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 noteworthy challenge in this still-nascent field: Strong, time-tested company reporting standards remain a work in progress among ESG practitioners.
For example, “Why and How Investors Use ESG Information” suggests one of our biggest decision-making challenges is “the lack of comparability of reported information across firms.” The report further 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 for any evidence-based investment approach. 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 described in part II, investors, advisors, and fund managers alike 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, Thomson Reuters and others. There also is a plethora of relative newcomers, each offering its own approach and perspective.
Given the assortment, a 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 offers an illustration: “[The] global head of ESG research at MSCI, says the aim of its ratings is to highlight financially relevant [ESG] risks; 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 you (and your advisor) will want to understand the differences among various ratings, and what they signify, so you’re not inadvertently comparing your “apple” results with “orange” benchmarks.
This leads us to our next point …
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, as reported in “Sustainable Investing: From Niche to Normal,” a CDP (Carbon Disclosure Project) is aimed at encouraging companies to report their greenhouse gas emissions; the UK requires all its listed companies to do the same. And “GRESB is an investor-driven organization of 250 members who 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. As reported in a June 27, 2018 Financial Advisor piece, “Advisors Say ESG Compliance Is Hard To Verify,” Cerulli Associates 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 aforementioned 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.” The authors note, “Governance is the most well-researched factor. The data has been in company filings for decades.”
Some investors may 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, if they’re created at all.
Cultivating Research Standards
There’s one more avenue to explore. How do we balance an investor’s desire to invest “ethically” with our fiduciary duty to advise them according to their 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 bull markets and bears; here and abroad; and across stocks, bonds and other 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. Which have actually delivered better returns under what conditions, and with what risks? To date, we continue to see energetic debates and compelling evidence contributing to our understanding of these important issues. Given the level of investor interest, academics and practitioners alike are working to resolve the various riddles and create the necessary body of evidence to achieve this high standard of excellence.
As such, we will continue to collaborate with other evidence-based professionals and academics. Together, we hope to discover and deliver increasingly effective ways to incorporate sustainable investing into investors’ globally diversified portfolios. We’ve only just begun!
At the same time, we understand that you may not want to wait decades to invest more sustainably. In fact, you may already be unwilling to invest otherwise. You deserve solid advice on how to make the most of today’s existing sustainable investment solutions, come what may as the future unfolds. Whether you’d like to get started right away, or simply remain informed, we stand ready to assist. Call us anytime to continue the conversation.