Fotolia

Recent trends show that investors are actively seeking to align their investments with their values to create a positive outcome.

Chris McKnett is a Managing Director of State Street Global Advisors. He is the head of the firm’s global Environmental, Social and Governance (ESG) investments business working across asset classes, investment teams and functional domains to champion sustainable and responsible investment on behalf of SSGA and its clients. His responsibilities include investment, product and business strategy. Chris is a member of SSGA’s Proxy Review Committee and State Street’s Executive Corporate Responsibility Committee and Senior Leadership Team. He earned his MBA from the Daniels College of Business at the University of Denver and a Bachelor of Science from the University of Connecticut.

Mirtha is Global Head of State Street’s Center for Applied Research. She co-authored the study The Investing Enlightenment: How Principle and Pragmatism Can Create Sustainable Value through ESG, with Prof. Bob Eccles, which proposes a five-step model for effective ESG integration. Mirtha has over 14 years of experience in the private and public sector, analyzing capital markets and helping shape public policy. She spent six years as a Global Macro Strategist at State Street Global Markets in Boston. In the public sector, Mirtha served as an advisor to the Secretary General of the Ministry of Economics in Nicaragua. Mirtha also worked at the Economic and Commercial Office of the US Embassy in Managua, where she received a Meritorious Honor Award by the US Department of State. Mirtha earned a bachelor’s degree with honors in Finance and Economics from Ave Maria College in Nicaragua and a Master’s Degree in Business Administration from the Brandeis International Business School.


Christopher P. Skroupa: There has been mounting evidence that companies with high ESG performance see greater investor interest and better financial performance. Could you talk a little bit about the benefits of implementing an ESG framework in an investment portfolio?

Chris McKnett: I think it’s important to approach this question from first principles, and consider why investors adopt ESG.  We know that for a long time, many investors have sought to align their portfolio with their values and principles, whether they are organizational values in the case of institutional investors, or individual values of retail investors.  The benefit in these instances is first and foremost that alignment, and importantly we have seen that investors needn’t sacrifice risk adjusted performance in pursuit of that alignment.  More recently, we have seen investors look to take a step a further and try, through their capital allocation, to shape an outcome that actually furthers their values, or creates positive change.  A good example is investing in firms with more gender diversity or with more resource efficient operations, to name just a few.  

In both of these instances ESG is part of the outcome.  Another benefit to implementing ESG in an investment portfolio is as an input into the investment decision making process that seeks to improve the investment outcome in the traditional sense: more return or less risk.  This is what ESG integration is really all about – harnessing data-rich insights to enhance an investment process.  The argument for doing this is relatively straightforward, which is that ESG represents risks and opportunities that could be overlooked by relying on financial measures alone.  Clients have told us that benefits from ESG incorporation have been achieved. Clients have told us in “Performing for the Future”, a survey and research executed by Longitude Research in association with SSGA that this has been achieved, with the vast majority (84%) of asset owners telling us they are satisfied with the performance of their ESG strategy, including 31% who are very satisfied.

 

Skroupa: So on the research side, what recent trends have you observed in ESG investment patterns? Do you feel like certain areas in the ESG field are producing greater returns?

Mirtha D. Kastrapeli: Our research shows signs of some encouraging trends on ESG investing. Our survey of 582 institutional investors interested in ESG investing provides evidence that investors are considering ESG strategies for the right reasons. Almost half of our respondents associate integrating ESG factors into investment decisions with better investment practices, and two-thirds said that ESG supports a long-term investment mindset. Furthermore, growing interest in ESG is not a response to regulation. In fact, only 18% of investors say their interest is driven by regulatory requirements. And it’s not a fad. Only 10% of institutional investors say peer pressure is what’s driving their decision to consider ESG issues.

What is also significant is the fact that traditional barriers to ESG investing are receding — specifically concerns about underperformance, fiduciary duty and performance timeframes. Although these barriers haven’t completely disappeared, one of the first surprises in our research found they were much lower than is commonly believed.

However, the barrier that stood out, across both retail and institutional investors, was a lack of standardized, good quality data. The most frequent barrier noted by institutional investors was the lack of standards for measuring performance (60%). Lack of ESG performance data reported by companies, was the second most frequent barrier (53%).

 

Skroupa: Obviously, the ESG investment philosophy has been gaining traction among large-scale institutional investors. What key challenges have you faced in integrating ESG elements into the investment process?

McKnett: It has been gaining significant traction and I believe that one reason for that is the “proof of concept” effect from existing track records and investor experiences. So while there’s more buy-in to the ESG investment philosophy than ever before, it’s not one-size-fits-all and there are still some skeptics out there, and that’s okay. Another reason for progress has been the forward looking nature of ESG, in contrast to the mostly backwards looking nature of some earlier iterations of ESG which excludes securities on ethical or religious grounds. In other words, ESG can be a lens by which to understand some of the transitions that are unfolding across the global economy, and how individual investments are positioned in light of these large scale trends. So ESG can be a tool for investors to prepare a portfolio for the economy of the future, which we know will not be the same as today’s economy, but this forward looking view is by definition difficult to prove empirically, for example with a back test. So some investors still struggle with the value proposition of ESG and gaining more performance conviction, and terminology confusion has been no friend to these endeavors. Another big challenge is again, data. It’s difficult to measure and benchmark performance, as Mirtha has mentioned. The data environment has been improving rapidly with remarkable innovation in data sciences, but still has some way to go.  Consider this: at the moment we have an array of ESG ratings in the market that in the best of cases go back to the early 2000’s, whereas the data we have around the Fama-French factors that seek to explain many of the drivers of investment risk and return has a history going back to 1926.    

 

Skroupa: What opportunities have you each observed, both from the research and investor strategy perspectives, in pursuing ESG-oriented investments?

Kastrapeli: With challenges comes opportunity. I mentioned that the biggest barrier today to ESG integration, according to our research, is the lack of good quality, standardized data.  Investors have the ability to help solve this data gap by asking companies for the data they need. This can be done via effective engagement. Also, data is only useful if it can be used in achieving investment goals. That requires a clear understanding—and demonstration—of which ESG factors are material for financial performance. Two-thirds of institutional investors now believe that it’s possible to build models that show the relationship between material ESG factors and financial performance. With access to data and the application of a ‘materiality filter’ on these data, our industry can unlock the opportunities that ESG investing and integration in particular can bring.

McKnett: We think that at the same time that investors in a muted-return environment are thinking about tilting their portfolios towards long-term, durable factors to enhance return, risk and diversification, our research shows that investors can also incorporate their views on ESG risks and opportunities to target even more sustainable portfolio performance. The big opportunity is the ability to achieve an investor’s ESG and financial goals, and that these can go hand-in-hand.  If in the process the incorporation of ESG helps to foster a longer-term mindset and adoption continues to increase, then the potential ramifications for the real economy, for our planet and society, from more sustainable investment are really exciting.