THE merits of integrating ESG (environmental, social and governance) criteria and sustainability into an investment decision are clear, argues one fund manager.
According to Amundi Asset Management head of equities Kasper Elmgreen, doing so will add value both in terms of being able to deliver better risk-adjusted return as well as in terms of helping to put focus on and ultimately improve important ESG parameters for companies and society.
The ongoing Covid-19 crisis and the resulting market turmoil, Elmgreen notes, have only confirmed the increasing relevance of ESG in equity investing.
“ESG equities have proved resilient throughout the crisis, both in terms of flows and performance, ” he says.
“On flows, ESG equity funds – including active and passive worldwide open-ended funds – have experienced net inflows both in 2019, and so far this year, while non-ESG equity funds have seen net outflows. On performance, ESG criteria have proved to be a source of outperformance both over the long term and recently, ” he adds.Detecting opportunities
With ESG investing becoming increasingly relevant, it will be key for active investors who look to generate excess returns to detect those opportunities where the ESG premium is not yet priced in fully.
For Amundi, a way to do it is moving from a static best-in-class approach to a dynamic and forward-looking one, seeking tomorrow’s ESG leaders.
“ESG winners are quality companies with attractive valuations and strong ESG ratings, while ESG improvers are corporates portraying a solid fundamental investment case and an improving ESG trend, but not yet an ESG leader, ” Elmgreen says.
“A combination of the two, in our view, will allow investors to benefit from the improvement in ESG ratings before a trend materialises and the premium is established. Hence, it will be important to include both ESG winners and ESG improvers in portfolios, ” he says.
ESG analysis should go hand in hand with fundamental analysis in order to assess the sustainability and profitability of each corporate’s business.
This will be especially relevant in the aftermath of the Covid-19 crisis, when many public funds will be available to drive an economic renaissance and policy authorities could increase scrutiny over how those funds get invested, Elmgreen argues.
Amundi recommends the following three steps to unlock value from ESG improvement:
> Identify the most material ESG drivers for each business;
> Understand the financial impact of those drivers; and
> Detect how those drivers will evolve in the future.
Companies can be mapped based on their ESG score: ESG improvers are the ones that display some potential to become the ESG leaders of tomorrow. In this trajectory, valuations will adjust, as shown by the United Nations’ Principles for Responsible Investment, MSCI and others. Identifying the companies at an early stage of ESG rating migration will be a source of value for investors.
“We believe that an optimal portfolio will combine both features, with the ESG leaders acting as a sound quality foundation, while the improvers will offer an additional source of potential growth and return, ” Elmgreen points out.
As Amundi sees it, the ongoing Covid-19 crisis is likely to bear long-term consequences on equity investing, reinforcing the equity divide between ESG and traditional non-ESG, with the former enjoying large structural demand.
Such trends are evident from the 2020 fund flows data available thus far, which show significant outflows from non-ESG equity funds, as investors have de-risked portfolios in the wake of the pandemic-related market sell-off.
However, strong market volatility has not derailed the large structural demand for ESG equity funds, which have proved resilient, enjoying consistently strong inflows.
“To put it simply, there are steady asset inflows into responsible companies which have not been worn away by the crisis and involve both active and passive ESG equity funds, ” Elmgreen argues.
For reference, the year-to-date ESG equity funds inflows have already beaten the inflows recorded in 2018 as a whole. From a financial standpoint, ESG criteria have proved to be a source of outperformance. (see charts)
Over the past three years, the ESG leaders MSCI indexes have all outperformed their respective non-ESG index on a total-return basis.
“While investors have been aware of the merits of investing responsibly for a long time, the current crisis is likely to increase the focus on ESG principles. That should play a critical role in the emergence from the crisis, ” Elmgreen says.
Amundi notes the current global economic recession (due to the fallout of Covid-19) is the first one of the ESG-investing era.
It explains, as in previous downturns, the solution to the crisis came from economic textbooks, with the political will, together with monetary and fiscal stimulus providing a path to recovery, this time, both governments and corporates will have to focus even more on the human component of the recovery, with factors such as rising inequality, healthcare, remote learning access, remote working and access to primary goods and services for the most vulnerable share of the population.
“We believe that ESG investing will be a structural force for asset managers going forward, ” Elmgreen says.
And looking ahead, he adds, how companies behave currently will have long-lasting financial implications on their businesses.
In this aspect, Amundi points out that historically, many companies have been managed purely for the benefit of shareholders. Today, they are increasingly managed in the interest of a wider audience of stakeholders beyond shareholders, including employees, customers, suppliers, and governments.
Corporates that fail to consider their wider responsibilities will face reputational damage in the short term and fundamental headwinds in the longer run that could weigh on their financial performance, it explains.
On what lies ahead, Amundi says it expects continued strong traction for the de-carbonisation trend in the energy and utilities sectors, moving towards more eco-friendly power production.
On energy, it sees integrated oil companies increasingly focusing on natural gas over oil with some also making significant investments in renewable energy.
“Utilities are increasingly moving towards green electric power generation. Such a move has been welcomed by financial markets based on their recent performance, ” Elmgreen says.
Outside of the environment-only perspective, the move towards smart mobility, smart factories and smart cities is generating growth opportunities in areas such as information technology, capital goods, and transportation, which are set to benefit from those trends.
In the consumer space, Amundi sees the recent crisis as a health crisis which has re-focused consumers on the importance of health and healthcare.
“As such, we see growth opportunities in areas such as nutrition, with consumers increasingly demanding healthy alternatives to traditional food and beverages, ” Elmgreen says.
Essentially, a comprehensive and fundamental approach which takes into account all three pillars, namely, environmental, social and governance, and a holistic approach will allow investors to capture structural and cyclical trends across industries.
The key, according to Amundi, is to invest in a portfolio that is constantly improving its ESG footprint.
After all, ESG investing, it says, is dynamic, and, as such, needs to be managed in an agile way to take advantage of market trends at any given point in time.
Did you find this article insightful?