What is ESG investing? ESG (Environmental, Social and Governance) investing is, first and foremost, investing. While a common misconception is that investing with ESG principles comes at the expense of investment returns, we disagree with this view and believe the integration of ESG considerations instead makes us smarter investors. By combining ESG data and analysis with traditional financial metrics, we can develop a more nuanced assessment of a company’s long-term risks and growth opportunities. The growing body of academic studies support this: 90% of findings from more than 2200 studies show a neutral or positive relationship between ESG and financial performance1. With the ever-rising popularity of ESG and a surge in both active and passive options, we believe investors should take the following into consideration when pursuing ESG investments:
Passive Alignment does not Equal Active Integration
The increasing availability of ESG data and ratings in recent years has driven a proliferation of passive products. However, many of these passive products simply focus on ESG alignment through either screening out “sin stocks”2 or by optimizing for ESG ratings, rather than focusing on the integration of material ESG factors into fundamental, bottom-up investment analysis. We acknowledge and appreciate the desire to align investments with ESG principles, but believe that ESG investing should go one step further by focusing on how ESG analysis can potentially drive better risk adjusted returns. We at GSAM Fundamental Equity have long considered ESG factors in our investment process, as we philosophically believe stronger ESG companies will drive more sustainable returns over time. Active managers seek to drive value in part by finding material insights that are not priced in by markets yet. In a rapidly changing world, we believe that investors that use a broader set of data and insights – including ESG data – as part of this holistic analysis may have a competitive edge.
Be Mindful of ESG Data
The quantity of ESG data has increased over the last 5 years, but we believe major quality issues remain, particularly in emerging markets. Fundamental equity managers seek to exploit flaws in data and classification to drive alpha while mitigating risk, by filling data gaps using fundamental bottom-up analysis and active engagement. We believe a deep understanding of a company’s operations and financial statements is necessary to analyze ESG data in a thoughtful way, and that simply relying on high-level ESG scores (which we believe focus too heavily on having and disclosing ESG policies, as opposed to actual performance on material ESG issues) can lead investors astray. In fact, companies that focused on material ESG factors were estimated to outperform those that focused on immaterial ESG factors by 5.41% annually.3 Having more ESG policies and disclosure does not necessarily indicate better ESG practices. For example, we believe that an energy company’s positioning and trajectory with respect to the transition to a lower-carbon economy as compared to its peers offers much more meaningful investment information than a high-level ESG score based on immaterial factors and whether or not a Company has produced certain policies.
Action is Stronger than Words
One of the potential benefits of an active approach to ESG investing is the ability to promote corporate improvement on ESG over time. Active and fundamental managers may be better positioned to achieve this goal through a combination of engagement and “acting with one’s feet” – that is, the ability to actively buy or sell shares based on views of the company’s ESG performance and trajectory. Passive ESG managers may also engage with companies to drive change, but the equity ownership decision is ultimately made by the index provider which may limit the potential to engender change.
GSAM Fundamental Equity is a leader in ESG integrated investing, launching our first dedicated ESG strategy over 10 years ago, long before ESG became a focal point in the investment management industry. Our long experience has taught us that ESG analysis requires an integrated, bottom-up approach driven by a focus on engagement in order to be properly executed. Our locally-based team across 6 regional hubs speaks over 10 languages and conducts over 10,000 company meetings a year, uniquely positioning us to achieve a high level of engagement and promote improvement. This active engagement informs our research, allowing us to overcome challenges in disclosure and “raise the bar” for corporate standards while finding attractive investment opportunities.
For more information on our engagement efforts, please see GSAM’s latest Global Stewardship Report.