How to stay out of trouble with ESG-related investments

Rarely has there been such consensus about environmental, social and governance investing than in the public comments on the Department of Labor’s recently proposed rule regarding the use of ESG investments in ERISA-governed portfolios. As cited in a recently published report, a whopping 95% of the comments expressed opposition.

With the proposed rule, the DOL implies that financial advisers and asset managers would ignore or de-emphasize their primary duty to their clients with ERISA portfolios by buying funds or stocks with high ESG ratings while paying scant attention to the investments' financial and risk characteristics. However, this implication is unlikely at best.

Don’t get me wrong: Most ESG-geared ETFs and mutual funds select their holdings exactly that way. The typical fund is tethered to an underlying index, therefore, the fund’s sector exposures must align with that of the index, but actual holdings may differ.

The ESG score becomes the decision point; generally, the respective sectors are filled with the stocks that have the best ESG scores. In such cases, most — if not all — traditional financial metrics are either minimized or ignored.

However, for those uber-precious retirement assets, there is a poorly understood array of strategies that can achieve both goals by integrating ESG ratings as data points in the investment process. If financial advisers choose not to buy individual stocks, they can invest using actively managed separately managed accounts, mutual funds or ETFs that judiciously seek out the “best” stocks as determined by a matrix of considerations. What the DOL has failed to grasp is that today, ESG items can be financial factors, capable of creating value or exposing liability, and account or fund managers alike can capitalize on that information.

This is not new. Good analysts have been identifying and evaluating the financial impact (positive or negative) of environmental, social and governance issues as part of their proprietary deep dive into a company’s financials. What has changed over the last five to 10 years, however, is that these ESG-related matters have been named, aggregated and elevated, so they bore into the thought bubbles of both investors and investment analysts.

As a result, there is no lack of information or opinion here. ESG-dedicated research companies investigate the "financial materiality" of ESG-related issues, and traditional Wall Street analysts are racing to jump on the bandwagon. A company’s actions related to “E,” “S” and “G” are now quickly parsed into potential financial advantage or liability, often resulting in as many different opinions as there are research firms.

Investment managers can use the ESG financial materiality ratings on a qualitative basis or quantitative basis. At Logan Capital Management, we designed GrowthPlus, our ESG-sensitive growth strategy, to be a natural extension of our growth strategies by mirroring the use of both quantitative and qualitative inputs to the investment process.

At the top level of the process, quantitative ESG financial materiality scores are integrated directly into our proprietary universe-creation algorithm, which is based on a range of financial metrics. All told, this produces an ESG-sensitive, growth-geared universe of stocks from which to choose. The qualitative ESG category scores are employed during the much-later granular final stock selection phase, thus ensuring the congruence of the investment processes.

Regardless of what happens to the DOL’s proposed ruling, ESG-related investing is not going away. Many studies and surveys by investment firms like Morgan Stanley, academics and consultants to the industry have shown that interest in ESG has skyrocketed, with millennials and women (two of the fastest-growing segments of financial advisers’ books) demonstrating particular interest.

Additional studies, such as this one by Morningstar, have shown that ESG-themed funds have performed better than the underlying indexes they are tied to over medium to long time frames, and most recently, during the March downturn. There can be many reasons for the outperformance, and in my opinion, future performance studies would benefit from more granular factor analysis. But the outperformance is there, and investors and their managers are eagerly following the phenomenon.

So to potentially stay out of trouble with ERISA-governed funds, stick with actively managed strategies that evaluate ESG investments based on financial materiality metrics, or pick your own stocks based on the same criteria. On the other hand, for clients who want to put their non-retirement assets into the stocks of companies that are doing the right thing for the environment, on social issues or that have governance activities aligned with their visions, invest away.

Deborah G. George is managing director at Logan Capital Management.