Somehow ESG has yet to emerge as a fundamental driver of value. If the CFA Institute 2015 member surveyon ESGis any guide,downside protection and investor mindset — not alpha —have been the key motivators of interest in ESG.
It isn’t a surprise that the world’s biggest active funds have relatively poor ESG rankings. While this could very well change, given the current lackofinterest in ESG factors, any shift would likely result from end investor demand rather than a systematic investing approach. The who’s who of signatories to thePrinciples for Responsible Investment (PRI)of the United Nations (UN) confirms a trend: The world’s biggest government funds, perhaps supported by direct community interest, are at the forefront when it comes to incorporating ESG considerations in investing.
While other investing concepts — value investing, for example —have attracted devoted followers for decades, socially responsible investing (SRI) has failed to generate a similarlevel of idea- and action-driven momentum from the investment community.
The underappreciated nature of ESG considerations, particularly in emerging markets, is an attractive opportunity.
So Where Is the Money?
Geographically, 99% of the world’s sustainable investing assets are in the United States, Canada, and Europe. Though this statistic may not be wholly accurate, it suggests that there issignificant underpenetration of ESG factorsin emerging markets.
But how do ESG principlesdeliver value? There are severaldistinctive approaches, according to thepractitioner literature. Chief among them arenegative or exclusionary screening and positive or best-in-class screening.
Negative Screening
Businesses must follow environmental and social performance standards mandated by regulations. Deviations from these regulatory norms can have investment implications ranging from the negligible to the destructive. Almost every couple of years, companies with shallow ESG records end up as case studies in value destruction.
While the governance aspect in ESG is important, the environmental and social aspects in particular are a source of significant liability and potential value destruction. Due to the possibility of steep losses, avoiding problematic companies or sectors is the most common sustainableinvestment strategy. As of 2014, negative screening strategies accounted for about US$14.4 trillion of the roughlyUS$21.4 trillion sustainable investing assets.
Positive Screening
The market has yet to grasp ESG improvement as a source of alpha for an asset or security.With regard to emerging markets, and India in particular, Aditya Arora of GEF investment advisors has an interesting insight: It is relatively easy to identify companies at theextremes — those with either poor or fantastic ESG records. Most fall in the middle, and this middle ground offers opportunities to investors who are willing to look.
There are companies whose promoters have no intention to tighten ESG standards, while others have stakeholders who are willing to improve but lack the knowledge or the foresight to do so. Investors could work with these promoters on their ESG records, orlook for changes in companies that are moving up the ESG performance curve. Thiscan result in significant alpha to investors as they benefit from a valuation multiple expansion, better capital allocation, and improved cash-flow quality. It is similar to junk or high-yield investing — generating returns from high yield and price appreciation.
The Promoters
Capital sourcing and structural hurdles, including regulatory uncertainties, make it difficult to start and run businesses in emerging markets. Scaling a business to an internationally recognizable size is even more challenging. But ignoring ESG norms to build a business could create permanent walls against growth and capital formation. Investors in developed countries may not even consider companies with shaky ESG records.
Positive screening ESG opportunities may be easily available only in emerging markets. There are, however, broader principled stands managers can make, as some did when they avoided fossil fuel investments.Had others followed their lead, investors would have dodged the significant market correction and price swingsof the last two years. The oil story is far from over — prices could recover, recouping the losses.
Still,avoiding unsustainable investment choices is not a theoretical fad but a robust downside protection mechanism and an attractive outperformance opportunity that deservesattention.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit:©iStockphoto.com/Konstantin Yolshin
FAQs
A second key result noted in the paper is alpha when both the material ESG score and the immaterial ESG score are jointly used to rank firms. Fig. 4 depicts the alpha relative to the portfolio of firms with low performance on both Material and Immaterial ESG issues (Low, Low).
What is ESG emerging markets? ›
The MSCI Emerging Markets (EM) ESG Leaders Index, is a capitalization weighted index that provides exposure to companies with high Environmental, Social and Governance performance relative to their sector peers.
Is ESG's role in Never Ending Quest for alpha is central? ›
ESG investing will never consistently outperform the market any more than any investment strategy or criteria can. However, ESG factors will increasingly be a central element of the toolkit that we use in training the investors and professors of the future and that they use in the never-ending quest for alpha.
Is CFA certificate in ESG investing worth it? ›
While the CFA ESG Investing Certificate is a valuable credential for finance professionals, it does have its limitations: It may not be recognised across all industries and in all countries as a standard of proficiency in ESG investing.
Does ESG have alpha? ›
Assets with higher ESG scores have negative CAPM alphas, whereas assets with lower ESG scores have positive alphas. Consequently, agents with stronger ESG preferences earn lower expected returns.
How to calculate alpha? ›
How do you calculate alpha? The formula that calculates alpha is: Alpha = R - Rf - beta (Rm - Rf). In this formula, R represents the portfolio's return, Rf represents the risk-free rate of return, beta represents the systematic risk of a portfolio, and Rm represents the market return, for each benchmark.
Is ESG an emerging risk? ›
Corporate Social Responsibility (CSR) and Environmental, Social, and Governance (ESG) are increasingly important considerations even for private-owned companies and not for profit organizations.
What is an ESG target? ›
ESG goals are the non-financial metrics that a company uses to assess their governance standards, social responsibility and environmental influence.
What is behind ESG? ›
Environmental, social and governance (ESG) is a framework used to assess an organization's business practices and performance on various sustainability and ethical issues. It also provides a way to measure business risks and opportunities in those areas.
What is the end goal of ESG? ›
Adopting ESG principles means corporate strategy focuses on environment, social, and governance. This means taking measures to lower pollution, and CO2 output, and reduce waste. It also means having a diverse and inclusive workforce, at the entry level and the board of directors.
ESG stands for Environmental, Social and Governance. This is often called sustainability. In a business context, sustainability is about the company's business model, i.e. how its products and services contribute to sustainable development.
What is ESG factor tilts? ›
Active managers of fixed-income portfolios who seek to reduce risk exposure and achieve favorable positioning with regard to an industry, company, or particular issue may want to increase their consideration of environment, social responsibility, and governance (ESG) factors.
How hard is the CFA ESG certificate? ›
Comparing it to other CFA Institute Certificates, the CFA ESG is on par with the Investment Management Certificate (IMC) in terms of difficulty, but it is considered easier than the CFA Level 1.
What happens if you fail CFA ESG exam? ›
Candidates who fail the exam and re-register will receive the benefit of a reduced registration fee of USD 690 for each subsequent examination. If you fail the exam twice within a six month period, you will not be permitted to register again until six months after the date of your first failed appointment.
How long does it take to study for CFA ESG investing? ›
To study for the CFA ESG certificate exam, candidates with no professional experience in ESG investing should expect to study around 100 hours. Candidates with professional experience in the curriculum topics should anticipate studying around a little less than 100 hours.
What is the meaning of alpha in equity? ›
Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market's movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment's alpha.
What does alpha mean in valuation? ›
What is Alpha? Alpha is a measure of the performance of an investment as compared to a suitable benchmark index, such as the S&P 500. An alpha of one (the baseline value is zero) shows that the return on the investment during a specified time frame outperformed the overall market average by 1%.
What is alpha in equity? ›
Alpha is a metric used to determine an investment's ability to beat the broader market or a benchmark index. Denoted by the Greek letter 'α', Alpha is used to measure the value at which a stock's performance deviates from the performance of a benchmark index.
What is alpha in risk analysis? ›
Alpha is one of the five major risk management indicators for mutual funds, stocks, and bonds. In a sense, it tells investors whether an asset has consistently performed better or worse than its beta predicts. Alpha is also a measure of risk. An alpha of -15 means the investment was far too risky given the return.
