A guide to a more sustainable portfolio

From small beginnings, environmental, social and governance (ESG) factors have become important considerations for asset managers globally. As you will see in this wire, there is no one-size-fits-all approach to sustainable investing. We will share the knowledge and experience we, at Robeco, have gained from decades of sustainable investing. After detailing the main approaches, we will examine how we apply sustainability techniques across asset classes. Ultimately, this guide will provide you with better sustainable investment solutions and enable you to truly understand the power and growth trajectory of ESG and sustainable investing.

Typically, the asset management industry broadly uses three approaches to sustainable investing and addressing ESG issues in portfolios.

The most common is the use of exclusions – avoiding investments in companies that produce controversial products such as weapons or thermal coal or are involved in controversial practices such as the production of unsustainable palm oil. For some investors, this is their only form of practicing sustainable investing, which means they may miss out on the benefits of using the other styles.

The less common, but more comprehensive approach is systematically integrating ESG factors into portfolio construction. This means analysing financially material information in order to make better-informed investment decisions and thereby improve the risk/return profile of a portfolio.

The third of these approaches is impact investing, where an investor wants to make a socio-economic impact as well as enjoy financial returns. This is often done by targeting themes or initiatives such as the UN SDGs. While exclusions are the most widely used means of negative screening, impact investing is a form of positive screening, where the focus is on deciding what to put in portfolios instead of what to leave out.

The three common approaches of sustainable investing – exclusion, integration and impact – come together when ESG criteria are thoughtfully built into the investment process and tailored according to the specificities of each asset class and portfolio objective.

In general, ESG analysis in equities seeks to identify an upside that is not necessarily reflected in the share price, while analysis in bonds seeks to expose any downside that may not show up in its credit rating. We believe that the big advantage of ESG integration is that it works across all asset classes – it has been proven to work just as well in fixed income markets as in equities. It can also be applied to commodity or real estate portfolios or private equity.

Fundamental developed markets equity  

Integrating ESG factors into the investment process leads to better-informed investment decisions. ESG integration in fundamental equity investments can be seen as a three-step process, illustrated in the figure below. The first step is to identify and focus on the most financially material ESG issues affecting the company. The second is to analyse the impact of these material factors on the company’s business model. Thirdly, the challenge is to incorporate these factors into the valuation analysis and/or the fundamental view of the company in order to decide whether to buy the stock.

 

Identify material ESG factors

Focusing on the most material factors is key, and this will vary by company or industry. Analysts should plot the highest likelihood of an issue making an impact against the degree of this potential impact. A huge number of data sources is used in order to gain the information needed to assess the likely impact of all these factors.

In Figure 5, you will find an example of IT services and related companies. Innovation management is the most material issue, followed by human capital management and corporate governance. Environmental management, however, is a relatively low risk, since IT companies generally have a low carbon footprint and generate little pollution. Other industries are of course different: for the pharmaceutical industry, the ESG issue of paramount importance is product quality and safety.

 

Analyse the impact of material factors on business model 

In the second step, analysts look at how the business model of a company is exposed to the material ESG factors identified in step 1. In-depth analysis should be conducted, including delving deeply into a company’s value drivers, such as sustainability of growth in an industry; a company’s competitive advantage; and market share. Analysts can then benchmark a company’s financial and ESG performance against its peers and industry best practices, and also assess the impact this may have on valuations.

ESG criteria: quantify the impact on value drivers 

In the third step, the impact of the ESG analysis is integrated into the valuation assessment. If the ESG impact is substantial, for example, traditional value drivers such as sales growth and margins or the weighted average cost of capital are adjusted. The ESG analysis may also result in altering a company’s competitive advantage period: the period over which it can generate excess economic returns. The impact of material ESG factors can be positive or negative, reflecting risks or opportunities that ensue from a company’s ESG analysis.

ESG performance isn’t the only reason to buy or sell a stock. However, if ESG risks and opportunities are significant, the ESG analysis will impact a stock’s fair value and the decision of whether to buy a stock – or not buy it.

Fundamental credits 

Fixed income funds have different priorities than their equities counterparts when using analysis to find the best bonds. In general, ESG analysis in equities seeks to identify an upside that is not reflected in the share price, while analysis in bonds seeks to expose any downside that may not show up in its credit rating. This has produced a well-known phrase that in credits, it is “better to avoid the losers than necessarily always picking the winners”. The risk of default remains the paramount threat and is much higher in sub-investment grade (high yield bonds) than in investment-grade securities. The key focus of credit analysis is therefore the cash-generating capacity of the issuer and the quality of its cash flows.

 

ESG criteria: corporate ratings 

In a fundamental credit strategy, the credit research analyst should ideally integrate ESG factors in their analysis. To be meaningful and relevant, the factors considered should be financially material and have a potential impact on an analyst’s fundamental view of an issuer. The weight assigned to these sustainability factors will vary from sector to sector and even company to company because different sustainability issues and themes affect different sectors and companies differently. It is important to integrate these factors within a structured framework to ensure consistency of analysis over time.

One example of ESG integration is using a structured format assessment for credit analysis consisting of five different factors. ESG is one variable; the other four variables are the company’s business position, corporate strategy, financial profile and corporate structure. Based on these five factors, the analyst assigns a fundamental score. For example, at Robeco, these scores range from +3 for highly positive to -3 for highly negative and are called ‘F- scores’. These express the overall fundamental view on a company given its credit rating. The five factors are not stand-alone but are often intertwined; for instance, a change in ownership can impact a company’s financial position, and an international expansion strategy may introduce country-specific risks into the business position.

 

Getting a lower F-score does not necessarily mean that a company’s bonds cannot be bought. Instead, this higher risk should be reflected in a higher credit spread versus its peers. In practice, a lower F-score therefore means that an investor would demand a higher spread to compensate for the additional risks that become apparent from our analysis. If the additional risk is not reflected in the spread of a corporate bond, an investor may opt for bonds with a better risk profile. Such a decision can be altered if either the risk profile improves or the spread rises to an adequate level.

Conclusion 

There are many ways to approach the incorporation of sustainability into investment portfolios. When considering different asset classes, different methods are better suited than others. Many tools should be incorporated into the underlying investment research, with others adding value. It is clear that there is no one-size-fits-all approach to sustainable investing.

However, over the course of time, consensus has grown on what approach fits various types of investors best. Investors at one end of the spectrum only consider financial criteria, while those at the other only consider social criteria, including philanthropy. Institutional investors generally have a focus on strategies in which sustainability is considered to mitigate risks, enhance value or create impact, alongside achieving competitive returns.

For an investor new to sustainable investing, creating a sustainable strategy may be easier if the process is broken down into more manageable chunks. The first step should be to define a purpose: what do they want to achieve with sustainable investing? The second to discuss and assess the motivations for sustainable investing with stakeholders such as sponsors, participants and clients. 

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The speed with which SI has become mainstream has left many advisers at a disadvantage in their ability to explain sustainability concepts to their clients. Bridge your knowledge with our latest insights. Visit Robeco’s website for more information.