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Novus Editorial

The Case for ESG

Investments that consider environmental, social, and corporate governance criteria are rising. This is accompanied by a major data challenge.

Andrea Gentilini
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I was recently talking with a CIO about the university endowment he manages, when he said something that struck me.

“I can’t live with the fact that we may own, directly or not, an economic interest in gun manufacturing businesses while the students of this university are marching the streets in Washington protesting for gun reforms,” he said.

He’s not alone in his predicament. Asset allocators and fund managers around the world are seeking a way to align institutional values with investments. These values may include diversity, sustainability, or a commitment to avoiding companies reliant on child labor.

ESG has been on the margins of the investment world for years. That’s changing. Driven by investor demand for responsible investing and the search for new ways to manage risk, investment vehicles that take into account environmental, social, and governance (ESG) factors have grown to a current estimate of more than $20 trillion. That’s roughly a quarter of all professionally managed assets around the world, and ESG’s share is expected to keep rising.

In the past, investors might not have paid attention to, for example, the gender pay gap at companies where they own shares. Those days are ending. Institutional allocators—especially those with a very public profile—can no longer afford to ignore ESG investment criteria.

But with this imperative comes serious challenges involving the collection and presentation of relevant data. With well over a hundred ESG rating categories and individual scores that change daily, simply corralling that data is a massive job in itself. Novus is addressing the data challenges of ESG, allowing investors to use the data instead of spending their time organizing it.

A European Example

ESG has caught on overseas more quickly than in the United States. More than a third of Asia-Pacific and European investors said in 2016 that ESG considerations were a significant factor in their decision not to commit to a private equity fund. Only a fifth of U.S. institutional investors said the same.

Norway’s sovereign wealth fund offers an intriguing approach to ESG investing. The Government Pension Fund Global was created in the 1990s to invest surplus revenues from Norwegian petroleum. The fund has a special focus on certain ESG topics that carry relevance across multiple sectors, including children’s rights, climate change, and water management.

The fund is very transparent about how it handles ESG, even publishing the firms they refrain from investing in on their website, along with the reasons for excluding each.

Norway’s fund monitors ESG factors largely to mitigate risk, betting that investments in companies with high ESG ratings will perform better over the long term. The bet appears to be paying off: the fund’s investments generated a 6% annualized gain from 1998 to 2018.

NBIM Return
Source: nbim.no/en/the-fund/return-on-the-fund/

Whether ESG investing downright outperforms other approaches is still up for debate. That said, a growing body of evidence suggests that incorporating ESG factors into investment decisions can in fact reduce volatility, provide downside protection, and potentially enhance returns—especially over the long-term horizons that apply to most institutional investors.

However, ESG is about more than performance. Institutional investors have a moral obligation to make money the right way, and, done properly, ESG is better for the world. People can disagree on some of the finer details of ESG issues, but few would argue against the ethical imperative for corporate values such as consumer protection, sound health and safety policies, and cultures that build trust and foster innovation. We should invest in companies that embrace these principles, and refrain from the ones that don’t.

The Need for Automated Measurement

To get serious about ESG, we need to start with the basics—measurement at the individual security and portfolio level. Investors must be able to assign ESG scores to the securities they own, have owned, or are considering owning.

There is a vibrant and growing industry made of firms that specialize in scoring publicly traded companies along one or more ESG dimensions. But we’re still in the early days of ESG investing, and the standards and metrics for measuring ESG exposures are in their infancy. Investors face the considerable challenge of trying to bring multiple scoring methodologies and assumptions into a cohesive analysis of all securities across a portfolio.

Moving forward, data must be organized and presented in ways that facilitate analysis, insight, and smart decision-making. Deep dives into specific ESG criteria must be complemented with broad measurements across multiple dimensions. And rapid iterations must be possible to keep up with ESG data that is constantly changing.

There is a richness in the wealth of approaches to ESG scoring, but the challenges it presents are real. In the next blog post, we’ll explore how Novus is automating the collection and presentation of ESG data to make it more relevant for asset allocators.

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