ESG factors are used in public market portfolios in a variety of ways, with some active managers using ESG factors as an integrated part of their fundamental approach to investing. These investors posit that a focus on companies with better ESG practices, in addition to good financial characteristics, will potentially lead to better risk management or may result in alpha generation. In passive portfolios1, however, an investor can choose to use ESG factors to better align a portfolio with his or her values, for example by emphasizing certain characteristics (e.g., companies with better human rights practices, or a higher “S” score), or de-emphasizing certain characteristics (e.g., companies with lower carbon emissions, or a higher “E” score). As opposed to active managers, which generally look for financially material ways to integrate ESG factors into their investing process, passive investors are generally looking for financially immaterial ways to integrate ESG factors.
When analyzing the ESG score of any passive portfolio, an investor must first identify the key qualities or metrics that he or she wishes to emphasize. While many data providers offer a single ESG score for an individual security, which is a composite of many different individual factors, using such composite metrics to evaluate either a holding or a whole portfolio implicitly assumes a common set of ESG values across investors. What is socially responsible to one investor, however, may not be to another. With databases containing hundreds of different ESG indicators reflecting various corporate attributes, a focused approach to both understanding—and then utilizing—ESG data can be highly valuable.2 Given the multitude of ESG indicators, investors have looked to outside sources for guidance in sharpening their perspective. For example, many institutional investors have placed a high degree of focus on the levels of greenhouse gas emissions represented in their investment portfolios, in the wake of industry initiatives such as the Montreal Pledge and the United Nations Environment Program Finance Initiative (UNEP FI), as well as popular movements such as fossil fuel divestment protests.
In addition to determining which ESG factors to focus on, investors need to determine how to measure the relative value of a given ESG metric. Three main approaches exist, as investors may compare their ESG score to: (i) peers managing comparable portfolios; (ii) a common benchmark index; or (iii) the investors’ own history. The appropriateness of each approach depends on an investor’s particular situation including, for example, the risk profile of the portfolio, the composition of stakeholders, and any fiduciary obligations.