How ESG factors can get messy

Risk management software provider Axioma asks why is it so hard to incorporate ESG factors into the investment process?

Claiming to incorporate ESG factors in investment processes is fashionable, but is hard to implement and even more difficult to evaluate the impact, according to a risk management software provider.

“Incorporating ESG factors into portfolio construction can’t hurt, but it is difficult to show that it helps,”said Olivier D’Assier, head of applied research at Axioma, a provider of portfolio optimisation and risk management software.

The main problem is that ESG (environmental, social, governance) factors overlap with more conventional factors which are used in the portfolio construction process: it is difficult to dis-aggregate the respective impacts and distinguish how ESG metrics might be contributing to alpha or mitigating risk.

Nevertheless, regression analysis can identify performance attribution from actors such as value and growth, with what’s left over — the residual performance — perhaps accounted for by the inclusion of ESG metrics.

“But, ESG factors in general are notoriously noisy, imprecise and often subjective,” D’Assier told FSA in a recent interview.

First, the portfolio manager might have simply selected the top 100 companies from an in-house ESG screening process. But, the number (in this case 100) would be arbitrary and the process might be unscientific.

Large companies typically have better ESG metrics than smaller firms, likely due to bigger PR departments

“A manual methodology is not an effective substitute for a quantitatively-driven optimiser,” said D’Assier.

Losing objectivity

Second, using third-party sources for ESG rankings can lead to a spurious objectivity.

“The ESG factors and their relative weightings differ significantly across vendors,” he said.

D’Assier offers a hypothetical example: take two companies, each with 12 people on their boards. One has 12 men, the other has six men and six women. The latter would gain a higher score for diversity – even if those twelve individuals were all white, from the US and had studied at Harvard, while the all-men board are from diverse backgrounds, countries and ethnicities.

Basically, bad data in, bad data out.

Third, large companies typically have better ESG metrics than smaller firms. That’s not necessarily because they are more ethical in the operations; instead it is more likely that their better-resourced PR departments recognise the importance of at least appearing more ethical.

Finally, ESG disclosures are still largely voluntary anyway — although there is clearly a move towards mandatory reporting in Europe, where the emphasis is on environmental impacts, and in the US where governance is becoming a key issue.

“Asia is quite late to the game, and the incorporation of widely-held ESG principles is complicated by the diversity of countries and cultures within the region,” said D’Assier.

However, D’Assier is convinced that ESG factors will become increasingly important for portfolio construction, even if the financial benefits now are not yet evident.

“I suspect that as more and more investors incorporate ESG in their strategies and we move towards a global standard for ESG metrics, and regulators across the world start to enforce ESG reporting, then these factors will start to trend like traditional factors.

“But as of now they do not, although we can see the beginning of some systematic return if we focus on the last four years,” he concluded.

This article first appeared on ESG Clarity‘s sister site, Fund Selector Asia.