Four Asset Managers Explain How They Incorporate ESG Data

Susana Peñarrubia is skeptical of the growing swath of portfolio managers who say they’re aggressively incorporating environmental, social, and governance (ESG) information into their investment processes.

As the head of ESG integration at German asset manager DWS, she’s obviously a believer in the value of these metrics, but her contention is that many are just scratching the surface at best, and at worst going through the motions for the sake of marketing or to tick the box.

“My feeling is that most asset managers still say they are integrating ESG, but they are just looking at the ratings—and this is not integration,” Peñarrubia says.

She is by no means alone with that opinion.

As climate change has driven investor demand and new risk management concerns, buy-side firms have been trying over the last few years to understand how to achieve fully integrated ESG considerations into their investment strategies. Firms say third-party ESG ratings are a good start for research, but analysts have to go much deeper for true insight into the companies and sectors they cover.

As a result, many asset managers are looking inward and developing their own robust data practices: building proprietary datasets, and looking to alternative data, quant strategies and new metrics for impact investing. WatersTechnology spoke to the people who are heading up these efforts at four asset managers, which differ greatly in size and scope, but all of who are looking for ways to solve this problem.

• Covid Concerns: Unlike in past financial crises, ESG is taking center stage as social and governance data is directly relevant to all companies weathering the coronavirus pandemic. That makes the holes in that data, which still remain, all the more apparent. Click here to read more.

Good Ratings

To get a rounded view of the ESG space, buy-side firms have turned to the large data and research providers like Bloomberg, Morningstar, MSCI, Refinitiv, and S&P Global; specialists like 1010Data (credit card transactions), Advan Research (geolocation), Dataminr (sentiment), Predata (geopolitical), Thinknum (web); and/or aggregators and brokers like Eagle Alpha, M Science, YipitData, and Quandl.

As asset managers have increasingly looked to incorporate ESG—as a discipline—into their overall strategies, the data provider space has seen a fair amount of consolidation. Last week, Morningstar acquired Sustainalytics, in what is just the latest move by a big data provider nabbing a specialist; S&P Global acquired RobecoSAM’s ESG ratings business as well as Trucost; MSCI acquired RiskMetrics, GMI Ratings and Carbon Delta; Moody’s acquired a majority stake in Four Twenty Seven and in Vigeo Eiris; and Institutional Shareholder Services (ISS) has acquired Oekom Research, IW Financial, and South Pole Group’s Investment Climate Data division.

ESG data offers a lot of noise, though, and as such, sources like Peñarrubia say it necessary to look beyond the indexes. It’s crucial that they take in data from several of these third parties, since the providers’ ratings are not correlated. There is no such thing as a consensus view on a company, as providers have different definitions of ESG performance, or measure performance differently, making it difficult to find a signal.

In fact, researchers at MIT Sloan’s Sustainability Initiative found that the correlation among five providers’ ESG ratings was on average 0.61. They compared this to credit ratings from Moody’s and S&P, which were correlated at 0.99. This means that the information decision-makers receive from ratings agencies is relatively noisy, the researchers said, and consequently, users will struggle to identify ESG performers and laggards.  

As Peñarrubia says, ESG ratings tell only a small part of the story of a company’s actual impact on society and the environment. Most firms are developing their own ways of understanding this reality beyond what third parties’ scores can tell them.

UBS Asset Management

As one example, UBS Asset Management, with $902 billion in assets under management (AUM), has developed metrics for measuring the social and environmental impact of companies. The firm partnered with the Harvard School of Public Health and the City University of New York to judge whether a company’s products and services promote the United Nations’ Sustainable Development Goals on public health, food security, access to water, and climate change. UBS is using the metrics in a $1.2 billion portfolio of public equities that it is managing for Dutch pension fund PGGM Investments.

Christopher Greenwald, head of sustainable and impact investing research and stewardship at UBS Asset Management, says that 10 years ago, sustainable investing (SI) was about picking the best companies to invest in. Increasingly, however, firms are looking to invest in the difference a company makes in the world; it’s about channeling capital to those whose activities are more beneficial in the long run. But this is still a nascent discipline, and a lot of work needs to be done developing metrics, Greenwald says.

The metrics UBS developed with its academic partners will give a more holistic view of a company, Greenwald says. For example, an analyst could look at a certain technology, perhaps a motor that is improving the fuel efficiency of trucks. They could then estimate how that technology reduces CO2 emissions versus the technology it’s replacing.

“And then by looking at product sales, one can get a sense of CO2 emissions mitigated by the use of that product. That is just a single data point, but you can bring that back to looking at the overall CO2 footprint of a company by linking it with emissions from the company’s own operations,” he says. “This net impact calculation is an element that has been missing from a lot of sustainability analyses.”

UBS’s ESG integration in general has been driven across the group—in the investment bank, as well as the asset management and wealth management divisions—by CEO Sergio Ermotti and chairman Axel Weber, to link it with investment processes and product development. In the asset management side specifically, the role of global head of sustainable and impact investing was created in 2016 and filled by Michael Baldinger, former CEO at RobecoSAM.

Integration means that our analysts take sustainability considerations into account when they are making their fundamental recommendations. This is done across fixed income and equities, so it’s quite broad from an impact perspective, and affects $300 billion in assets.

Christopher Greenwald, UBS Asset Management

The team under Baldinger now comprises 18 people, says Greenwald. “Our goal has been to broaden our efforts beyond just sustainability funds, to more broadly integrate into the research across asset classes, and to develop more index- and rules-based strategies integrating sustainability,” he adds.

Also, around three years ago, UBS Asset Management began to develop its own data taxonomy for internal use to categorize strategies, including ESG integration.

“Integration means that our analysts take sustainability considerations into account when they are making their fundamental recommendations. This is done across fixed income and equities, so it’s quite broad from an impact perspective, and affects $300 billion in assets,” Greenwald says. “It is a focus on materiality from a financial and risk perspective, and this will differ across sectors and industries; [it’s about asking] so what are the factors that can affect companies’ performance?”

The firm also has explicitly sustainability-focused strategies, with rules linked to sustainability governing portfolio construction.

“This could be, for example, a best-in-class strategy with active equities, which we have had for more than 20 years, but it could also be a passive or rules-based strategy,” Greenwald says.

UBS Asset Management’s Climate Aware World Equity Fund, for example, tracks the FTSE Developed Index, but applies tilts to reduce investments in companies with high carbon emissions, or to increase investment in renewable energies companies. 

Greenwald says the firm is seeing significant growth in these kinds of strategies: Assets in SI-focused strategies have risen from $5 billion three years ago to about $39 billion now.

Thirdly, UBS AM has impact strategies, which are investments in companies with positive social or environmental impact, and that also generate returns. “This is the next generation of where sustainable investment likely will evolve over the next five or 10 years,” Greenwald says.

Greenwald’s team has developed an ESG risk dashboard that brings together scores from several different providers, as well as screens on governance and controversy flags. The dashboard is integrated with data visualization software, which UBS uses for a variety of research frameworks, but has been customized for ESG issues.

But the real work, Greenwald says, is “the analysts applying the data to the investment cases. Research integration cannot simply rely on third-party data and screening portfolios and that is the end of it. Just as third-party financial data are starting points, analysts must go to the next level to apply that information to their investment cases.”

DWS Group

Similarly, Peñarrubia says DWS has chosen to chase a more holistic approach to integration. The firm began ramping up ESG integration in the late 2000s, starting with buying data from a single provider.

But it’s not enough to have the data—you must also know how to use it, Peñarrubia says. So in 2010, the firm trained all its analysts and portfolio managers on the European Federation of Financial Analysts Societies’ (EFFAS’) course in valuation, measurement, and integration of ESG issues into investment analysis.

In 2016, the federation launched a formal ESG certification, and DWS made this compulsory for all investment staff. DWS now consumes data from seven providers, and has more than 100 EFFAS-certified ESG analysts.

At the same time, DWS improved its database to provide a centralized source of information for analysts or portfolio managers that would allow access to ESG reports on companies within seconds. Globally, DWS uses Aladdin, BlackRock’s investment management platform, but has customized it for the ESG investment process with the integration of its own proprietary platform, ESG Engine. ESG Engine pulls in the data from seven external providers to score companies, and incorporates that with Aladdin’s research system, so that all analysts and portfolio managers, whether in ESG strategies or not, can access a view of ESG risk whenever they like.

Something was missing that was extremely important: how to integrate the E, S, and G in the evaluation of different companies.

Susana Penarrubia, DWS

This centralized view of risk has also proven useful for compliance, calculating performance attribution, and for portfolio monitoring, Peñarrubia says.

After these efforts were mostly completed in 2016, Peñarrubia says the firm was ready for the next step: teaching analysts to dive deep into the analysis of the risks and opportunities that might affect the valuation of companies.

“Something was missing that was extremely important: how to integrate the E, S, and G in the evaluation of different companies. So we had internal training in 2016 to show people they could use E, S, and G to look at risks and opportunities—not just to see a rating, but to say, ‘What is the impact this information may have on the sustainability of the business model going forward? How could this affect the competitive position of the company?’”

This deep-dive approach is much more difficult and time-consuming than just looking at some ESG ratings and making a recommendation.

“To get a feeling for every company we have in the database, there are about 2,000 datapoints per company. This means that analysts are facing a situation where they must analyze a lot of new topics and information, assess if there are risks or opportunities for the company, and estimate their financial impact. Most of the training since 2016 has been explaining to people [what] appropriate due diligence would [look like for] integrating E, S and G factors and global trends in their investment processes, from identification of the critical ESG aspects per sector, interpretation of the signals they get from our ESG database, to the monitoring of the ESG quality of their portfolio,” Peñarrubia says.

But it has been worthwhile, she says, adding: “People need to get more knowledge on what the metrics mean, the global trends, and how these affect the valuation of a security.”

Lazard Asset Management

Over the past year, Lazard Asset Management has been investing in additional resources to build a proprietary approach to ESG integration, says Jennifer Anderson, co-head of sustainable investing and ESG at the firm’s office in London.

Investment research at the firm is centered around a database where all analysts and PMs share and store their research on companies, their notes from engagements with companies, and their models. The database always had an ESG section in it for information on companies, but more recently Lazard has been thinking about how it could be improved: what datasets and metrics are still needed, and how is the firm going to develop frameworks around these for the different industries its analysts cover.

Lazard has affiliated with the Sustainability Accounting Standards Board (SASB), a non-profit that sets financial reporting standards, and that has produced some definitions around materiality. These standards provided a starting point in looking at materiality in each sector.

“But further to that, we have undertaken global workshops with our analysts that cover each industry to identify what is material from their perspective. We have been working across the investment platforms to develop frameworks for each industry that of course must be underpinned by the right datasets,” Anderson says.

The importance of collaboration with the quant side of the business has become increasingly apparent during this process.

Jennifer Anderson, Lazard Asset Management

Many of the frameworks Lazard is starting to build rely on looking at alternative datasets and finding ways to scrape data, or looking at machine-reading techniques to pull data in. “The importance of collaboration with the quant side of the business has become increasingly apparent during this process,” she adds.

Anderson herself joined Lazard about a year ago, along with her New York-based co-head Nikita Singhal. Singhal and Anderson have been working with Lazard’s directors of research to undertake the internal process of incorporating ESG in a systematic and robust way on Lazard’s investment platform. 

“A key point of difference for me in joining Lazard Asset Management was that there wasn’t a ‘separate’ ESG team, but that it was, in effect, everybody’s job,” Anderson says. “Our CEO, Jeremy Taylor, had taken the decision in 2009, when he was head of research, to follow an integrated approach, where analysts and portfolio managers were responsible for ESG analysis, whereas many of our competitors have large ESG teams that tend to operate in silos, away from the investment teams.”

Lazard uses the Symphony app, where about 150 users can talk on ESG topics in a dedicated group chat. It also has an internal forum for ESG. 

East Capital

In 1997, Hong Kong-based Karine Hirn co-founded East Capital, a specialist in frontier and emerging markets. Back then, she and her partners realized they were spending a lot of time thinking about information that wasn’t to be found in companies’ annual reports or earnings calls.

As a shareholder in Russian companies in the late 1990s, East Capital’s partners were especially focused on governance. They wanted to make sure the firm’s interests as a responsible investor were aligned with those of the companies they had stakes in. Did that oligarch want to raise money to make a sound investment in a soccer team? Or was he using his company to influence politicians, or process Communist Party transactions?

There were no key rules in the firm, but ESG considerations were always part of the analysis and normal investment activities, Hirn says. But last year, East Capital’s partners decided to kick it up a notch.

Hirn, who as a founding partner and a portfolio manager already wears a lot of hats, took on another one: chief sustainability officer, with the responsibility for driving full integration of ESG analysis in the firm’s investment process.

East Capital’s framework has four pillars, Hirn says. The first pillar is negative screening, which East Capital has been doing for about 14 years, excluding stocks from “sin sectors.”

“This is ESG 101, and I find it surprising that you still have asset managers getting headlines for doing this,” Hirn says. “But even this we do a bit differently. We ask our investment management teams to reconfirm every year that our stocks and the companies we own don’t have any activity in these sectors.”

Secondly, the firm uses norms-based screening, a method Hirn says is growing more common among asset managers. Norms-based screening involves excluding from portfolios companies that have failed to meet internationally accepted norms, set by organizations like the United Nations.

“This is about identifying companies that are accused of, or have committed violations of international norms and conventions, such as the UN Global Compact,” Hirn says.

The third and probably most important pillar was established in 2016, when East Capital developed its own scorecards on ESG. The firm had begun to look around for more ESG data, and realized that a lot of providers simply don’t provide coverage of emerging markets equities.

“You can buy data, but it only covers 40 percent of your portfolios,” Hirn says.

A lot of ESG data providers are not tracking these companies very closely, and instead track the availability of policies, not the actual practices.

Karine Hirn, East Capital

Also, some of the providers that the firm examined gave companies good ratings based on the availability of the companies’ policies.

“A lot of ESG data providers are not tracking these companies very closely, and instead track the availability of policies, not the actual practices. So a lot of companies have a policy on something, but might not actually be doing it in practice. Or smaller companies with fewer resources might be doing everything right, but aren’t necessarily good at documenting or enacting policies,” she says.

Hirn also realized that policies are subjective. Policies on, for example, gender inclusion on boards are not necessarily always the most material considerations. If a corporation had a high percentage of women on its board, it might receive a good governance rating. But what if those women were nepotism hires?

The answer for East Capital was to develop the scorecards—the fourth piece—which act as a tool to identify weaknesses that every company has, and inform the firm’s engagement with these companies as it pushes for improvement (engagement is the fourth pillar of East Capital’s ESG integration strategy).

“Preparing these ESG scorecards in a structured way implies consistency across our teams, and we have people all over the world. It also means that we put much more depth into analysis compared to buying external data,” Hirn says. “Doing the analysis is as important, if not more so, than getting a final score. Once you have done it, you know more about the company.”

East Capital uses the Bloomberg Terminal, which allows users to integrate proprietary sustainability data into its own models, which Hirn says is helpful. “And our project for the summer is to start using a customer relationship management system for all our contacts with our portfolio companies. This way, you can define engagements, track interactions, and of course, collect all investors’ information in one place,” she says.

The New Reality

Climate change will bring new kinds of risk and opportunities to the world that asset managers must contend with. Genuine ESG integration means that the analysis of environmental, social, and governance risks and opportunities is undertaken by the investment professionals who are steeped in the industry and understand the companies.

As Lazard AM’s Anderson puts it: “This allows them to contextualize ESG and incorporate it into financial models and forecasts, thereby ensuring that we make better, more holistic investment decisions. For example, the transition to a low-carbon economy is going to require significant changes in capital allocation. Active, engaged investors that have genuinely integrated ESG frameworks into their research and investment decision-making will be well placed to identify the winners and losers against the backdrop of extremely complex and interconnected issues.”