As Global Head of Research for MSCI’s Environmental, Social and Governance (ESG) Research group, Linda-Eling Lee oversees all ESG-related content and methodology and chairs MSCI’s ESG Ratings Review Committee. She leads one of the largest teams of research analysts in the world who are dedicated to identifying risks and opportunities arising from material ESG issues. The team, located in 12 offices globally, provides:
- ESG ratings of 6,000+ issuers;
- Industry and thematic research; and
- Analysis used by investors for positive and negative screening.
Lee joined MSCI in 2010 following the acquisition of RiskMetrics, where she led ESG ratings research and was head of consumer sector analysis. She joined RiskMetrics Group in 2009 through the acquisition of Innovest. Prior to joining Innovest, and was the Research Director at the Center for Research on Corporate Performance, developing academic research at Harvard Business School into management tools to drive long-term corporate performance. Previously, she was a strategy consultant with Monitor Group in Europe and in Asia, where she worked with Fortune 500 clients in industries ranging from beverages to telecommunications.
Christopher P. Skroupa: MSCI has established itself as an influential thought leader on ESG trends. What do you see as the top of mind trends for investors this year?
Linda-Eling Lee: The pace of change in everything – from policy and technology to climatic change – has made it difficult for companies to anticipate emerging risks to their businesses. Investors in turn are looking for ways to position their portfolios to best navigate the uncertainty. One trend we see emerging is investors increasing their focus on differentiating companies by the ability of their talent pool to quickly adapt to the era of artificial intelligence; their workers need to quickly upskill in order to capitalize on the potential of AI. While good workforce data is hard to come by, we find evidence that companies with stronger human capital management practices experienced better productivity growth than their industry peers from 2012 through 2016.
Skroupa: Your latest ESG paper finds a statistically significant causal link between ESG and stock performance – what was your approach?
Lee: There are an increasing number of studies showing a positive correlation between ESG and performance. We think that the data history and analytical approach are now at a stage where we actually need to go a step further than simple correlational studies. This year, we are writing a series of papers on the Foundations of ESG Investing that apply a more sophisticated approach to understanding the linkages between ESG characteristics of companies and portfolios and financially significant effects. One goal we had in the first paper was to avoid the risk of data-mining and to try going beyond correlation towards a view on causality.
We examined how ESG information embedded within stocks is transmitted to the equity market. Borrowing the language of central banks, we created three “transmission channels” within a standard discounted cash flow model. We call these the cash-flow channel, the idiosyncratic risk channel and the valuation channel. For the cash-flow and the idiosyncratic risk channels, the economic argument we test is that ESG characteristics should manifest in companies’ stock-specific value drivers and risk profile. The value channel, on the other hand, is linked to companies’ risk profiles that are systematic, such as their exposure to changes in the market environment, market prices or changes in regulation.
Using a universe of more than 1,600 global developed-market stocks from January 2007 to May 2017, we found that MSCI ESG Ratings provided valuable information for both systematic and stock-specific risks.
Skroupa: What is the relationship between ESG and higher profitability and valuations?
Lee: High ESG-rated companies tended to show higher profitability, higher dividend yield and lower tail risks. These characteristics are stock-specific, and transmitted through the idiosyncratic risk channels. We also found that high ESG-rated companies tended to show less systematic volatility, lower values for beta and higher valuations.
Skroupa: How can changes in a company’s ESG characteristics be a financial indicator?
Lee: In our analysis, the change in a company’s ESG characteristics over time, which we call “ESG momentum,” has been a leading indicator for changes in systematic and idiosyncratic risk. We think this analysis is important because it not only provides support that strong ESG characteristics have in this time period led to positive stock performance, but that ESG momentum may be a useful financial indicator in its own right and investors may choose to use this signal in addition to ESG ratings in portfolio construction methodologies. For instance, while not indicative of future performance, the top 20 percent of stocks based on ESG momentum consistently outperformed the bottom fifth during our study period.
Skroupa: Can ESG be considered a Factor in the traditional sense of the term?
Lee: The short answer is “yes,” but there are some important differences. It is important to keep in mind that even 10 years’ worth of the only data set that has been designed specifically to capture companies’ material risks is, relatively speaking, a limited time period for quantitative analysis. Over this period, MSCI ESG Ratings were associated with the likelihood of an individual stock suffering a large drawdown as well as with different levels of systematic risk. The latter suggests that MSCI ESG Ratings may be a risk factor due to their ability to explain systematic portfolio risks.
In addition, MSCI ESG Ratings experienced a longer life — lasting several years — than some factors, potentially making them useful inputs in the asset allocation process and policy benchmarks. In contrast, classical factors, such as momentum, typically have persisted for a few months only during the study period.
Skroupa: Why does ESG matter?
Lee: ESG matters to me, personally, because I have always been fascinated by measuring things that are hard to measure, yet really important to capture. I think most of us know intuitively that there are some fundamental characteristics of how organizations are run that cannot be captured by financial statements. And we observe every day that powerful socio-political and environmental forces are upending established business models. ESG matters because it’s information that can give investors a window into this intersection of big macro trends and companies’ ability to navigate them.
Linda- Eling Lee will be speaking on a panel at the ESG 4 Summit in New York, NY on April 5, where she will be interviewing multiple panelists on a topic to be announced soon!
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