Statement from Mirtha Kastrapeli, Global Head of the Center for Applied Research, State Street Global Advisors, provided in advance of the interview:
“The way we invest is fundamentally changing, and it’s changing because of technological, demographic and societal changes. In this new world, portfolios that are focused largely on short-term financial performance will have a harder time being competitive and relevant, particularly as alpha opportunities become more elusive and we continue to see fee compression.
Sustainable investing is an opportunity to reinvent our industry’s value proposition, by focusing on financial and nonfinancial factors to achieve not only better risk adjusted returns, but also consideration for issues that matter to our clients such as climate change, gender inequality, economic disparities and others.
Why do these issues matter? They matter not only because it feels morally right, but more importantly, in our industry, they affect the bottom line of companies. If we, as investors, are to do a comprehensive analysis of our portfolios and investment decisions, we need to consider these issues both from the perspective of risk as well as in the search of alpha opportunities.
ESG integration is a vehicle to achieve this, to bring responsible investment to the mainstream, because it focuses on values, and is relevant to all investors.”
Christopher P. Skroupa: How has your research affected your position on ESG integration?
Mirtha Kastrapeli: After almost 12 months of research, and based on input from more than 1300 market participants, at the vanguard of ESG integration, globally, and in conjunction with Prof. Bob Eccles, we are proposing a five step model for effective ESG integration, that can help close the gap between the aspiration or promise of sustainable investment and the action of ESG integration implementation. I’m happy to discuss that in more detail and it’s also in the paper The Investing Enlightenment.
Skroupa: Can you discuss the five step model for effective ESG integration?
Mirtha Kastrapeli: Yes, the steps are:
- Take ownership:
- In the case of investment organizations, decisive support from the C-suite and the Board of Directors on ESG issues is needed, just like any other major initiative. This is something that came loud and clear in our interviews;
- 30% of all institutional investors (582) said that explicit support from leadership was effective in reducing barriers to ESG integration. Interestingly, this was particularly important in the Americas with 39% of them saying leadership support is critical versus only 20% in Europe, Middle East and Africa (EMEA).
2. Get educated: This involves making ESG part of the investment lexicon and training on ESG across the investment organization:
- ESG integration cannot be done effectively when there is a sharp dividing line between the sector portfolio managers and analysts, and a separate, and usually small, group of ESG analysts who handle proxy voting and attempt to influence the decisions of the sector specialists. Our research, both from our surveys and interviews, showed that the number one practice, across all regions, for reducing barriers to ESG integration was to provide training on ESG to sector portfolio managers and analysts. To make ESG part of the investment organization’s DNA, if you will.
3. Ask: Ask for the data and the solutions you need. One of them is engagement.
- If the problem is access to data, the solution is simple. Investors should ask for it. A common complaint from companies is that investors don’t give them credit for what they are doing with “sustainability” and that investors never ask about their ESG performance, focusing instead on short-term financial performance. Investors, in turn, complain that companies don’t provide much in the way of useful ESG performance data and never talk about it on investor calls. In fact, 92% – a big number – said that they want companies to explicitly identify what they regard as material ESG factors that affect financial performance, and the only way to do this is through better understanding and communication about how nonfinancial factors affect company’s bottom line.
4. Incorporate materiality filter: Smart investing is not about access to all ESG data, but the right material data.
- Our research suggests that constructing this filter is ultimately the responsibility of sector portfolio managers and analysts. While it is useful for them to know what the company believes to be material and SASB’s standards can be helpful as well, these sector specialists must take ultimate responsibility for the materiality determination. With a point of view on the material ESG issues, sector portfolio managers and analysts skilled in ESG can then build investment models that incorporate both financial and ESG factors.
5. And lastly, align time horizons:
- As we have discussed in our past research, organizations need to adjust performance metrics and incentives structures to reflect the long-term nature of ESG investing. This was particularly the case for the Americas and Asia Pac, and less relevant in EMEA. Another example of a barrier that is not as prevalent in Europe versus the U.S. or Asia;
- Particularly for asset managers: AO showed more patience for tolerating underperformance. Asset managers feel more short-term performance pressure from their clients than the asset owners feel from their beneficiaries. The asset owner/beneficiary relationship is a “stickier” one and the mechanisms for beneficiaries to exert pressure on those managing their money are generally weaker. That said, neither group was particularly long-term with only about one-third of each citing three years or more.
Skroupa: What can investors do to encourage ESG integration by companies?
Kastrapeli: Effective engagement. As for the information you need, talk about it in an investors’ call. 92% of investors say that they want companies to explicitly identify what material is, so they need to ask for the information they need:
- Vicious cycle/Chicken and egg question: Companies have been complaining that investors don’t care about ESG issues or ask about them in investors calls, while investors say that companies do not provide them with the data they need;
- Changing that requires not only better data, but more importantly a better understanding and articulation of the relationship between ESG performance and financial performance;
- We need better data on a longitudinal basis to empirically better understand the relationship between financial and nonfinancial performance. Companies need to build their business models on this and explain them to investors. Investors need to do the same for their financial models.
Skroupa: Who is driving the demand for ESG-integration today? The Investors? The companies?
Kastrapeli: Both. ESG integration is happening at both the company and investor level. Companies, while still at early stages and with a lot of greenwashing, have been doing this for longer – driven by a desire for increased efficiency.
Investors are more recently moving to ESG integration. It’s still growing, and, for now, is not the most popular strategy – only 21% of the ESG investors are doing full ESG integration vs. 47% of exclusionary.
What’s encouraging is that we found investor interests in ESG investment strategies are on the rise. The market is becoming driven as 38% of investors cited demand from beneficiaries and 35% cited initiatives by executives as important reasons for integrating ESG factors into investment decisions.
There is also a request for long-term framework: two-thirds said that ESG supports a long-term investment mindset. However, only 18% say their interest is driven by regulatory requirements (12% in Asia, 20% EMEA and the U.S.), and only 10% of institutional investors say peer pressure is what’s driving their decision to consider ESG issues.
Skroupa: Is ESG becoming mainstream in that it is now getting the full attention in discussions between companies and investors, or is it still just a “soft issue” that does not need the full attention from the CEO and the board?
Kastrapeli: Mainstream would be overstating it, but the trend is in that direction. An encouraging point is that traditional barriers are receding.
One of these perceived barriers is the concern that ESG strategies will negatively impact investment performance. Our survey presents a more encouraging picture than we initially thought. In fact, almost half of institutional investors interested in this space (48%) don’t believe ESG means missing out on returns and only a third (35%) believe ESG means sacrificing returns. In the retail space, only a third (35%) of both ESG and non-ESG investors, say that they believe ESG will impact performance. When asked about barriers, concerns about underperformance of ESG investment was ranked fourth (only 29%).
The second perceived barrier is the belief that fiduciary duty prevents ESG integration: In the case of institutional investors, fiduciary duty is not seen as a major constraint to ESG integration. Only 10% see fiduciary duty as a barrier and in fact 40% of asset owners and 51% of asset managers see fiduciary duty shifting in the direction of supporting ESG integration.
Skroupa: Is ESG engagement with investors more important for small caps and start-ups (PE), compared to large listed companies?
Kastrapeli: Not necessarily. Maybe small cap stocks can use ESG to get better attention in the capital markets but they will typically lack the resources to do this well.
For PE, ESG integration has a big role to play there, with PE firms getting more and more serious. They hold these companies for longer than average public equity holdings and can get the ESG information and offer the proper governance to get the benefits from this.
Skroupa: Is it fair to say that we do not need more ESG data, but better? Is there an overload of data?
Kastrapeli: We wouldn’t say there’s an overload of data but more an overload of sources of data that are inconsistent with each other. For sure we need better data but this means data according to standards, proper internal controls and eventually audits. Big data is acting as a proxy for poor reporting by companies and lack of standards.
Skroupa: What is your take on the UN’s Sustainable Development Goals (SDGs)? Is it the silver bullet for ESG integration? Is it as “hot“ in Europe and the U.S. as in the Nordics?
Kastrapeli: From what I can tell, SDGs are hotter in the Nordics than Europe with the U.S. further behind. That said, companies and investors are paying more and more attention to the SDGs. For sure they aren’t a silver bullet for ESG integration. In fact, they’re really raising a different issue: impact and how to measure it.
A frontier which is related to but separate from ESG integration. The unit of analysis for the SDGs is positive and negative externalities in the world created by companies. ESG integration is taking account of how ESG issues affect financial performance of companies and investors.