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ESG: Cracking the Case

Given the rise of ESG, how can investors harness the richness of data that's available, and make the data harmonious with their portfolios?

Andrea Gentilini
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View Part 1 of this series, The Case for ESG.

A host of data providers now measure company performance on environmental, social, and corporate governance issues. They collect huge quantities of ESG data from company-sourced filings, proprietary surveys, and other primary and secondary research.

That’s the good news for asset allocators and fund managers interested in ESG investing. The bad news is the data is sparse, and formats, scoring methodologies, and update frequencies vary wildly between scorers. At Novus, we offer an automated solution that allows investors to ingest and process ESG data efficiently, helping them get to the insights faster.

Breadth vs. Depth

Companies that score ESG performance generally take one of two approaches. Some dive deeply into specific ESG criteria, offering corporate ratings on a few issues such as carbon emissions, child labor, or gender diversity. Trucost (Figure 1), for example, assesses environmental risks like natural capital costs and exposure to fossil fuels. Similarly, South Pole analyzes corporate climate risks and opportunities. RepRisk, on the other hand, zooms in on repetitional risks and helps companies facilitate compliance processes.


Figure 1: www.trucost.com

Other companies assign ESG scores more broadly, looking at multiple issues across all three general categories (environmental, social, and governance) without providing as much granular detail. The well-known analytics firm MSCI uses thousands of data points to score more than 6,000 companies on 37 ESG criteria. Swiss firm Covalence, meanwhile, collects data from other firms to create a wide-ranging scoring system. And Inrate uses a proprietary framework to assess the effect of environmental and social practices on company products and processes.

Focusing deeply on specific issues may lead to more accurate, nuanced scoring. Using the data, however, can be difficult. Investors must combine scores from multiple sources, trying to bridge disparate scoring methodologies and assumptions to create a cohesive analysis of all securities across a portfolio—the classic data harmonization challenge. Casting a wider net paints a more comprehensive picture, but may sacrifice depth and forensic accuracy.

Adding to the challenge, ESG scores change frequently due to shifts in company policies or leadership. In order to be of most use to allocators, ESG scores must be tracked over time and measured against portfolio dimensions such as exposures, returns, and risks.

Beyond Excel

Of course, most investors don’t want to track ESG data for all companies all of the time; they want to know how the data relates to their specific portfolio. What is the portfolio’s exposure, both short- and long-term, to ESG factors? How have these factors contributed to portfolio performance? How much would performance have benefitted (or suffered) if the portfolio had filtered out securities with low ESG scores? How have ESG factors affected volatility?

In addition: how have securities in their portfolio reacted to a higher or lower ESG rating? Is the magnitude of the reaction significant these days (we have evidence that it is), and how does that compare to a few years ago?

Basic software tools such as Excel worksheets aren’t capable of answering these questions effectively. Imagine having to assign more than 100 scores every day to the more than 1,000 holdings in the average allocator portfolio. You also have to integrate scores from different sources; weight scores based on position size and priority of each ESG factor; and keep the worksheet current as securities enter and exit the portfolio, and companies acquire or merge with other companies. It’s easy to imagine spending 98% of your time maintaining the worksheet and 2% using the data it provides (and tearing your hair out in the process).

This situation calls for a more industrial solution. Novus has developed data connectors that can automatically overlay ESG data onto your portfolio to monitor exposure and risks, while driving insights into the ESG factors that are influencing portfolio returns. Our technology takes scores from a variety of scoring companies (or from datasets provided by clients), weights the scores according to a defined aggregation logic, and marries the data to specific portfolio information already in our system.

Figure 2 below, for example, shows gross exposure by overall ESG rating (upper left corner), return on invested capital (upper right corner), and a scorecard of key exposures, risk, and attribution metrics. ESG scores were provided by MSCI for illustrative purposes.

ESG Investing 1

Figure 2: ESG dashboards facilitated by Novus

Figure 3 answers a more complex question: what is my over- and under-exposure by E, S, and G ratings compared to a broad equity benchmark? In other words, am I taking, as an investor, an active risk compared to the E, S, and G scores of my broad selection universe?

ESG Investing 2

Figure 3: Over- and under-exposure by E,S and G rating vs. broad equity benchmark

Novus enables investors to identify correlations between particular ESG metrics and asset performance and apply the analysis to specific portfolios. Novus can tell you whether a particular ESG metric’s effect on performance is statistically significant. Our platform also automatically and continually incorporates re-ratings, and measures any effect on price movements, through our breakthrough Event Analysis framework.

Figure 4 depicts one such example, where price trajectories before and after a re-rating are visually inspected, to easily determine whether a re-rating has a significant impact on price trajectories.

ESG Investing 3

Figure 4: Price trajectories before and after a re-rating

In short, investors have the opportunity to overlay ESG datasets on their selection universe, helping them measure their current exposures, understand how ESG drives performance, and make smarter investment decisions—for the sake of a better future.

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