The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
As the world grapples with major social, economic and political issues, ESG (environmental, social and governance) has become the ubiquitous acronym under which investors, financial institutions, corporations, and public policy entities develop guidelines and procedures to address these challenges.
ESG encompasses climate change, global health crises, poverty, diversity, business ethics, and many other issues. The complexity of these issues, and the differing perspectives of multiple constituencies, requires investment managers to be thoughtful and balanced in refocusing their investment processes and decisions.
As with any sound investment approach, it also requires flexibility, openness, and a commitment to continually incorporate new information and analysis in making long-term investment decisions.
There is no single best approach in addressing the challenges discussed above. ESG investing approaches cover a broad spectrum, with stringent exclusionary policies or negative screening at one end of the spectrum, and proactive, targeted impact investing on the other. In between these two extremes is a wide range of approaches to integrating ESG investing policies and strategies, including hybrid approaches which seek to balance exclusions with ESG optimization in managing investment portfolios. Whatever approach to ESG investing a firm undertakes, it must continue to manage client assets in compliance with applicable regulations.
Investor interest in ESG has been rising rapidly, with annual inflows into ESG-oriented funds climbing from $5 billion in 2018, to $21 billion in 2019, to $51 billion in 2020, according to Morningstar.i At the end of 2020, ESG-oriented funds held $236 billion in total assets, which represented a remarkable one-year increase of 70%, bolstered both by the rising influx of new investment dollars and by strong market performance.
That growing interest has incentivized mutual fund companies to launch new ESG-related funds or repurpose existing funds at a rapid pace. A record 71 ESG-oriented funds were launched in 2020 – nearly double the previous annual record of 44 in 2017 – to bring the total to 392 funds at the end of 2020.ii
With the rising interest in ESG has come increased scrutiny over the investment management industry’s ESG processes, research commitment, and, ultimately, portfolio construction. One aspect of this scrutiny is to ensure that investment management firms or mutual funds that purport to offer ESG strategies are true to that objective, and not just using ESG as a marketing tactic to increase assets under management – otherwise known as “greenwashing.”
Industry regulators, including the SEC, have been active in issuing statements and observations related to ESG processes and disclosures. This type of activity is expected to continue and likely increase with the rise in investor interest in ESG, the pace of ESG developments, and ongoing debate about whether there could be improved standards to compare practices among firms. Additionally, consulting firms and ratings firms have come out with opinions and guidance around this topic.
While ESG has taken root due, in part, to changing industry dynamics, its emergence has also contributed to those changing dynamics. This suggests that there may be opportunities for alpha generation when investing through an ESG lens.
For example, firms that address issues like climate change may be disrupting entire industries, like transportation. Consider the growth of electric vehicles as a case in point. This growth may encourage asset managers to evaluate the impact of electric vehicles on the entire value chain in search of opportunities. Companies in virtually any industry may also be employing capital to projects addressing ESG issues material to their business, which could create long-term value for shareholders and other stakeholders.
Incorporating ESG analysis is another dimension of risk management utilized while pursuing the optimization of client returns. It is this “middle ground” of ESG risk management where many large financial institutions, including TAM, have begun to direct their focus.
TAM has established an approach and structure to bring ESG analysis into our investment process. We have developed an overall philosophy and set of guiding principles, as well as a measured approach for implementing ESG analysis into our research and portfolio management process. We have also refined our organizational oversight and review process.
Broadly speaking, ESG analysis is the act of evaluating the investment merits of a company by focusing on its impact (positive or negative) on the environment and society, along with a deep dive into its governance practices, and can help identify emerging risks and potential opportunities facing a particular company. The following is TAM’s approach to incorporating ESG analysis as part of our process that seeks to deliver risk-adjusted investment returns that help clients achieve their goals.
TAM believes that ESG analysis can be a valuable input to rigorous investment research and risk management. When constructing portfolios, we recognize that issuers who promote high standards for sustainability, governance and social engagement may deliver favorable long-term investment returns. For example, certain studies have shown that companies that prioritize ESG projects that are material to their business may create more value than those companies that do not.iii
ESG analysis is being integrated into our investment process. This integration will be an ongoing, evolutionary process, as data and analytics in this area continue to improve. We have made a firm-wide commitment to reviewing ESG factors, with the extent of implementation in various asset classes and sectors determined specifically by each investment team.
Taking an integrated approach, TAM’s ESG conclusions by themselves do not prescribe either inclusion or exclusion of securities from portfolios. We review portfolio exposure based on ESG metrics provided by third parties in order to monitor the portfolios’ overall ESG profile.
Integrating ESG into existing fundamental and quantitative research disciplines may provide additional insights into financial and non-financial factors which can influence the long-term performance, risk, and suitability of specific investments and complement the research process. As such, it augments broader research efforts, rather than exercising priority over them, in an effort to improve overall investment conclusions. We incorporate ESG research using a non-exclusionary, industry-neutral framework.
Where we employ ESG analysis, we do so with the objective of informing both our bottom-up company and industry analysis, and our top-down risk management. On a bottom-up security-specific basis, ESG analysis complements our rigorous evaluation of drivers of risk and return. In instances where ESG-related issues present broader macro or systemic risk factors, ESG criteria provide an additional lever to help us manage the potential for external risk shocks. This allows us to focus on the bottom-up, research-driven strategies which represent our core source of performance advantage.
TAM evaluates companies using a range of research including reports, metrics, ratings, and scores. We acquire fundamental and quantitative information from third party providers, including providers of in-depth ESG data. The ESG criteria and data considered are tailored by industry for relevance and materiality. The ESG data pulled into our investment management systems includes ratings, momentum, controversy, and carbon data, with the ability to pull in even more. ESG research reports from third party providers evaluate issues considered material to a company and show how the company is managing those issues relative to industry peers.
On a macro basis, we seek to analyze external risks driven by poor ESG quality. This process seeks to evaluate potential exposures which might otherwise arise from valuation frameworks while establishing procedures for additional review or exposure management.
Given that much of ESG data is non-financial in nature, there may be issues with consistency, reliability, and standardization of relevant metrics. This can make evaluation and judgement difficult. Some information can be rather subjective or qualitative.
This is particularly true with social and governance metrics. Information can also be backward-looking or prone to corporate spin as company management works to build a favorable investment narrative. Also, there is a common criticism of the large ESG ratings firms due to low correlation of ESG “scores” among the ratings firms.
This highlights the issue of subjectivity or even bias in the analysis. However, there are efforts to address these issues. Some organizations are attempting to improve the integrity of ESG information through explicit standard setting and government requirements for accuracy and transparency in certain areas of information disclosure.
Additionally, there is a possibility that ESG objectives reflected in ESG data and information could conflict with investment objectives. All these caveats highlight the importance of doing extensive, primary investment research and not simply relying on outside evaluators when assessing ESG risk.
TAM maintains an ESG and Proxy Voting Committee, chaired by the Head of Thrivent Mutual Funds. The committee also includes the Chief Investment Strategist, Head of Fundamental Equities, and Director of Equity Research Program Administration, and is supported by a coordinator responsible for ESG information and reporting. This group meets at least quarterly to review portfolio metrics, research coverage, relevant updates regarding high profile ESG situations and areas of concern, as well as general ESG developments and topics.
As part of our ESG oversight process, we monitor, review, and evaluate controversial issuers, activities and developments. The committee seeks to understand potential controversies more clearly and ensure that the potential risks are thoroughly considered. TAM monitors portfolios based on a range of ESG metrics, including portfolio absolute and relative positioning by factor, rating, and scoring.
An example of a factor is greenhouse gas emissions while a rating is a single measure of ESG risk exposure analyzing a variety of data points using a methodology developed by a third party. Scoring includes the evaluation of factors material to a business such as severe controversies as measured by a third-party service. This information is provided to each investment team. We also monitor changes in ESG conditions among issuers as well as important news and industry trends to prompt special review by research, investment teams or the ESG and Proxy Voting Committee.
ESG analysis is an important dimension to investment analysis. It can help identify emerging risks, as well as potential opportunities, as individuals, corporations and governments respond to new and dynamic challenges.
TAM’s ESG approach will evolve as data and analytics improve, and as evidence continues to support the efficacy of incorporating this information into managing portfolios that generate risk adjusted returns that help clients achieve their long-term goals.
iMorningstar, “A Broken Record: Flows for U.S. Sustainable Funds Again Reach New Heights,” January 28, 2021
iiMorningstar, “U.S. Sustainable Funds Continued to Break Records in 2020,” February 25, 2021
iiiYoon, Aaron, George Serafeim, and Mozaffar Khan. 2016. Corporate Sustainability: First Evidence on Materiality. The Accounting Review. 91(6): 1697-1724
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.