Translating investors’ sustainability preferences into financial KPIs corporate management can relate to
There are three types of investors:
1. Fundamental investors that analyze the potential of a business model backed by a refined understanding of industry trends (currently the largest group)
2. Those that count on quantitative analyses to capture alpha potential and focus primarily on risk premium or factor investing (a smaller group but one that is vastly gaining ground against the fundamental investor)
3. Those who emphasize sustainability aspects in the investment process when evaluating business models (we believe this group will dominate the other two groups in the long term).
Corporate managers often struggle to interpret what the sustainable investor really wants because they believe there is no universal definition of what sustainability actually stands for – or is there?
The common denominator: Translating sustainability preferences into valuation frameworks
Wouldn’t it be helpful to be able to translate investors’ sustainability preferences into financial performance indicators that neatly tie into corporate valuation frameworks? Indeed. But the challenge, of course, is to figure out what investors really mean when they claim to invest sustainably, because if we ask a hundred portfolio managers how they define sustainability, we get a hundred different answers.
Instead, corporate managers should wrap their heads around the following questions:
1. What are the portfolio managers’ preferred methods for factoring sustainability aspects into investment strategies, among both active and passive funds?
2. Which datasets do they source from third-party vendors to structure and quantify these sustainability preferences?
3. What are the sustainability-related regulatory requirements that force investors to align their product offerings a certain way?
Once this is understood, corporate managers can anticipate how capital flows will change in the future and create a specific corporate investment profile deemed to be a sustainability leader in a given industry group. Why does the industry group matter? Because the ex-ante tracking error matters when comparing the risk-return profile of a fund to a given benchmark index. (If a model is used to predict tracking error, it is called ex-ante tracking error. Ex-post tracking error is more useful for reporting performance, whereas ex-ante tracking error is generally used by portfolio managers to control risk.) A commonly applied method for keeping the ex-ante tracking error in check is to start off with an industry-neutral stance before picking individual securities that offer the highest alpha potential for a given investment horizon.
This is why industry-specific ESG ratings are generally preferred over ESG ratings that result when weighted E, S and G ratings are compared across industry groups. For example, even when a company obtains the highest ESG rating in its industry group, this does not imply a high rank across the entire investable universe.
Relevant sustainable investing strategies benefit a specific type of investment profile
According to the Global Sustainable Investment Alliance, 36 percent of worldwide assets under management are already subject to sustainability commitments. We believe this share could surpass 80 percent by 2030 and 90 percent by 2035 and is yet to be reflected in asset prices.
In a recent 2020 review, ESG integration (70 percent of assets under management, up 14 percentage points on 2018) surpassed negative screenings (45 percent, down 21 percentage points on 2018) as the most frequently considered approach for embedding sustainability aspects into the investment process – ahead of corporate engagement and shareholder action (30 percent, unchanged from 2018).
ESG integration is the systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis. Negative screening refers to exclusions from a fund or portfolio of certain sectors, companies, countries or other issuers based on activities considered not investable. Corporate engagement refers to employing shareholder power to influence corporate behavior, including through direct corporate engagement, filing or co-filing shareholder proposals and proxy voting in accordance with comprehensive ESG guidelines.
Hence, the focus lies on sustainability aspects that are financially material: factors that have had a statistically significant effect on corporate performance or are likely to be impactful in the future.
And our analyses reveal that high-level sustainability KPIs, such as headline ESG ratings, have been more impactful on security prices than those from sub-categories, such as E, S or G ratings. Why? It is more likely that the majority of investors consider an ESG rating as opposed to the sub-component of a sub-component. This suggests to keep it simple instead of getting lost in the details.
Overall, we observe that there are mainly four sustainability datasets that most investors focus on when claiming to invest responsibly:
1. ESG ratings […]
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