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An investment focus on firms, combined with an emphasis on sustainable, high quality business models, can potentially uncover unique sources of alpha and deliver consistent outperformance for active equity investors. |
Why investors should care about ESG trend in US equitiesUS ESG (Environmental, Social and Governance) investors are increasingly likely to benefit as the country’s companies close the gap with best-in-class global companies on ESG disclosure and performance. The trend towards ESG in the United States is being driven by asset owners demanding ESG integration into corporate business strategies, investors using it as a source of alpha1, and regulators looking to formalize ESG into its rules and protocols. A growing body of empirical evidence suggests that companies with improving ESG momentum have been correlated with positive risk-adjusted returns. These ESG improvers are companies with solid business fundamentals that are demonstrating positive momentum in addressing ESG risks and opportunities. We believe that an investment focus on firms, combined with an emphasis on sustainable, high-quality business models, can potentially uncover unique sources of alpha and deliver consistent outperformance for active equity investors. 1Alpha is the excess return of an investment over a benchmark. Key observations:
US closing the ESG data gapEven without new federal regulations, improvements in ESG data and disclosures are gaining momentum among US companies. The lack of disclosure is a meaningful reason for the ESG scoring gap between US companies and what we consider to be global best in-class ESG:
1Alpha is the excess return of an investment over a benchmark. |
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Sustainable fund flows in the United States continued at a record pace in the second quarter, with estimated net flows of $10.4 billion, according to Morningstar |
Investor flows are a key driver of increased ESG disclosure
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Companies on an improving ESG trajectory can potentially provide a financial re-rating opportunity, which can impact their stock positively |
ESG momentum (i.e., ESG improvers) has generated alphaCompanies on an improving ESG trajectory can potentially provide a financial re-rating opportunity, which can impact their stock positively. Research from MSCI and the UN Principles for Responsible Investment (PRI) finds that ESG momentum, defined as year over-year improving ESG scores, boosted risk-adjusted returns between 2009 and 2018. Specifically, the PRI study concluded that companies in the United States stand to benefit from an upward trend in ESG scores, based on an analysis of a hypothetical portfolio measuring the performance of companies with improving ESG scores over a ten-year period ending in June 2017. |
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Further, the UN PRI’s US ESG momentum portfolio had better risk-adjusted returns relative to portfolios with static ESG ratings. This was based on the finding that the US component of the UN PRI portfolio had the highest information ratio, which indicates whether a portfolio is achieving a higher return in excess of the benchmark given the amount of risk taken, relative to other major global regions. If US companies improve their ESG profiles via best-in-class ESG practices and better disclosure relative to the rest of the world, we would expect a meaningful alpha opportunity, all else equal. Source: UN Principles of Responsible Investment, “ The PRI’s ESG and alpha study ”, March 2018. Information ratio measures risk-adjusted return by calculating whether a portfolio is achieving a higher return in excess of the benchmark compared to the volatility of the benchmark. The higher the number, the better the risk-adjusted performance. ESG as a predictor of earnings quality ESG is a predictor of earnings qualityA recent BofA study observed that ESG ranking was the best measure signaling future earnings risk, and was superior to leverage or other risk and quality. The study covered the period between 2005 and 2018. |
Given the post-Covid level of diminished earnings visibility, improvements in a company’s ESG profile should be a significant factor in future earnings quality |
Given the post-Covid level of diminished earnings visibility, improvements in a company’s ESG profile should be a significant factor in future earnings quality. The aforementioned acceleration of US ESG data and disclosures should provide earnings quality support when it is needed most. |
Under a Biden presidency and a democratic Congress, ESG regulations that follow Europe’s lead on data and disclosure would accelerate further the shrinking of the ESG profile gap that exists for the US market. |
A Biden presidency and a democratic Congress are likely to accelerate ESG momentum:ESG regulations that follow Europe’s lead on data and disclosure would accelerate further the shrinking of the ESG profile gap that exists for the US market. We think this will create opportunities for US ESG strategies versus the rest of the market. However, should Trump be reelected, the ESG theme is still underway, because of the aforementioned evidence of investor pressure for increased disclosure and better environmental and social practices, and supported by accelerating ESG equity flows, albeit not at the same level should there be a democratic sweep. A swing to Democratic leadership would accelerate ESG trends significantly, including the initiatives below that are now underway in Congress:
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Democrats are likely to push for greater environmental regulations related to materials, water and sourcing. |
Many Biden priorities reward those firms with strong or improving ESG profiles:
A Biden presidency could boost social policies.
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Proper integration of ESG into an investment process, with an emphasis on ESG momentum to identify ‘ESG improvers’, will be increasingly important to drive compelling risk-adjusted returns and outperformance versus traditional benchmarks. |
ConclusionBest-in-class ESG is an emerging theme in the US equity market, which is starting to close the gap with Europe as the long-time leader in ESG investing. The United States is seeing improvements in ESG disclosure, experiencing increased flows into ESG strategies by a broad range of US investors, and accelerating an increased focus by US companies on improving their performance with respect to key ESG considerations, particularly around the environment and social components. The prospect of a Biden Presidency and a democratic Congress are likely to accelerate the importance of ESG in US equities. We believe that proper integration of ESG into an investment process, with an emphasis on ESG momentum to identify ‘ESG improvers’, will be increasingly important to drive compelling risk-adjusted returns and outperformance versus traditional benchmarks. Further, we believe large asset managers players with a strong ESG footprint and experience are well positioned to offer investors compelling investment opportunities, as they developed methodologies, process, research capabilities able not only to detect the companies making strong progress on ESG, but also identify tomorrow’s ESG leaders. |
Definitions
- Alpha: The additional return above the expected return of the beta-adjusted market return; a positive alpha suggests risk-adjusted value is added by the money manager compared with the index.
- Basis points: One basis point is a unit of measure equal to one one-hundredth of one percentage point (0.01%).
- Beta: Beta is a risk measure related to market volatility, with 1 being equal to market volatility and less than 1 being less volatile than the market.
- Information ratio: A measure of portfolio management’s performance against risk and return relative to a benchmark or alternative measure.
- Open-ended funds: In these funds, investors have the choice of whether to partially or completely redeem their subscription on each redemption day, subject to the redemption terms specified in the fund’s offering document.