Should ESG minimize risk or capture opportunities?

Reviewing the latest papers from asset managers on how to incorporate ESG from a total portfolio perspective revealed an interesting question.

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Should ESG considerations be focused on minimizing the financial risk of improving ESG scores or focused on opportunities to enhance returns?

Early ESG analysis tended to focus on adopting negative screens and excluding companies that did not meet certain standards. However, it’s clear that today thinking has evolved to include a spectrum of approaches that have factors both to mitigate risk and capture better opportunities.

Whether ESG increases or reduces risks depends on how you measure it. A paper from DWS considers impact in terms of tracking error vs standard benchmarks. Under this definition, incorporating ESG increases your tracking error to the benchmark and thus increases risk. The investor therefore has a trade-off to make in terms of how much tracking error they are prepared to stomach in order to improve ESG metrics.

A paper from Schroders draws a distinction around short term versus long term risk. Schroders point out that as fewer companies and asset classes are included on sustainability grounds, it follows that less breadth in the portfolio will result in a higher risk profile. Exposure to acute shorter-term risks resulting from unexpected shocks, may be higher for portfolios that take a sustainable approach to investing. 

Therefore, both the DWS and Schroders analyses suggest that short term risk may indeed be higher. However, Schroders point out that over the longer term, the portfolio is likely to be better insulated against these risks. Therefore, if the asset owner's time horizon is long enough then such risks are of lesser importance.

So what about opportunities and potential financial benefits of incorporating ESG beyond the improved impact on people and the planet?

The most powerful expression of the opportunities from ESG investing came from reading a paper from AQR, where they distinguish between ESG beta and ESG alpha.

"ESG Beta is about getting better risk-adjusted returns from market exposure by removing inefficiencies and costs associated with poor management of ESG issues, thereby benefiting the collective investments of the fund.

However, unlike more-traditional risk premia, which are a reward for taking systematic risk, ESG Beta will not eventuate on its own. ESG Beta requires improvement in systematic efficiency to gain reward and that can only come about through change; change in consumer behaviour, social attitudes, regulation, or even through the cumulative impact of investors’ influence on companies and the allocation of capital."

AQR categorizes two types of ESG alpha. "ESG Change Alpha," which derives value from improvement in the underlying asset in order to create shareholder value; and "ESG Information Alpha," which seeks to capture a return premium through better use of available information - an ability to identify leading ESG management.

One conclusion of this is quite empowering. Both ESG beta and ESG alpha require individuals or collective action to realise. Therefore asset owners and asset managers have a great opportunity to influence outcomes and generate enhanced returns whilst also having a better impact on people and the planet.

What is your view? Should ESG be focused on opportunities or minimizing the financial risk of improving ESG scores?

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