In our view, investors have a window of opportunity in front of them, as increasing data disclosures will create alpha opportunities arising from the gradual closing of existing information inefficiencies. This will arise alongside the convergence of fundamental and ESG investing. This may also help uncover whether the risk factors embedded in ESG investing are unique and idiosyncratic or whether they can be readily proxied by traditional risk factors.
In particular, many dimensions of ESG are likely to evolve around quality as a factor – which is already present in traditional analysis – further confirming the convergence between ESG and fundamental metrics. How fast this convergence between ESG and fundamental worlds occurs will depend on the evolution of ESG demand. The function that determines ESG demand is not easy to forecast as it is unstable and not linear, as with investor preferences. ESG demand not only depends on investor appetite (flows) for some or all ESG elements, but it is also driven by the overall ESG ecosystem which comprises multiple forces such as regulatory change, coalitions, and legislation.
The net-zero emissions initiative is one of the most recent examples of an ESG ecosystem in motion, highlighting the theme for investors and further raising the impact of other climate change-related ESG factors on prices. At the same time, it provides an example of data evolution. Temperature scores are emerging as a complementary tool to other existing climate-oriented metrics for investors wanting to create net-zero aligned portfolios. With rising interest on temperature scores and an increasing push towards net zero, company’s temperature score profile is starting to improve quickly, especially in emerging markets.
Nevertheless, the task of creating a netzero portfolio is not an easy one, as very few companies worldwide meet the target, there are still strong data inconsistencies among providers and no standard approach to creating a portfolio with a net zero objective. This provides a fertile ground for alpha generation as investors may leverage all available ESG data and fundamental bottom-up assessments to try to determine a forward-looking view of a company’s net-zero trajectory.
While this data inconsistency persists, investors will be able to exploit these inefficiencies, but the room of opportunity may not last forever. Let us imagine there is a unique average global portfolio. As long as there is a sustained increase in demand for ESG assets and strategies, this demand will exert a price effect on the market, driving inefficiencies and risk premia down and prices up. This will continue with the rise in ESG demand and increase in ESG regulation, until a tipping point (equilibrium) has been reached when ESG and traditional investing are so interlinked that the ESG standalone definition will cease to be distinctive. This will happen when an ESG efficient frontier will be touched and no additional gains in terms of risk-return can be exploited from additional ESG input. In fact, only a few elements of ESG will remain unconnected, as most of them will already be integrated in the fundamental assessment. When this occurs, the pure ESG component will start to be less relevant (as only a few remaining marginal aspects will not be integrated into the fundamental framework) and its impact will fade in the market. Yet, this process may take a long time and may not prove to be a straightforward journey.