Michele Leung, Green Finance Advisor of Friends of the Earth (HK)
ESG integration, the use of environmental, social and governance (ESG) factors in investment analysis and portfolio management, has gained increasing acceptance in the past few years as investors recognized the profound impact of ESG risks and opportunities on their portfolios. Industry studies have showed ESG investing does provide better risk adjusted returns. Particularly for Emerging and Asian markets, outperformance is much more consistent and significant than what we observed in developed market. One study also showed excluding low ESG-ranked stocks could have aided the risk and return characteristics of a sample of China-focused active funds over a 5 ½ years period.*
ESG is also expected to have some downside protection nature. The COVID-19 pandemic provided the first real test of this hypothesis. Companies with strong ESG characteristics suffered smaller drawdowns in relative terms. Importantly, attribution analysis showed that a large part of this relative outperformance came from ESG and was not merely a proxy for other defensive factors, such as quality and low volatility. It explains why we are seeing more investors interests in ESG investments because ESG does provide resilience during the pandemic, as ESG investing helped to mitigated downsides.
All these studies reinforced the message that ESG gradually becomes a standalone factor, not only for investors looking at integration or regulatory compliance, but also in terms of financial outcomes, such as returns and risk.
In terms of ESG integration, there are numerous approaches for integrating ESG into portfolio construction—whether active or passive strategies—in equities or fixed income. Here are some common approaches.
- Exclude Business Activities: some investors may want to exclude controversial activities that are not aligned with their values, like tobacco, alcohol or controversial weapons, also known as negative screening
- Best-in-Class: some investors may want to focus on the highest rated ESG performers in each sector
- Impact Investing: some investors may want to focus on positive impacts on the society and environment, aligning to the U.N. Sustainable Development Goals
Essentially there is more than one way to integrate ESG into investment process. Hence, a well-defined investment objective would be an important first step for any ESG Integration.
*Source: MSCI Blog: Would Integrating ESG in Chinese Equities Have Worked? https://www.msci.com/www/blog-posts/would-integrating-esg-in/01970806830
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