Research Foundation Books 25 October 2018 Volume 4 Issue 7
Mainstreaming Sustainable Investing
Mainstreaming Sustainable InvestingView the full book (PDF)
“Mainstreaming Sustainable Investing” is the title, tagline, and guiding principle of the annual Sustainable Investing Seminars run by CFA Society Boston since 2013. In that first year, the idea of “mainstreaming” sustainable investing seemed wildly aspirational to many. Yet by the time the society held its fourth annual seminar in November 2016, aspiration had been surpassed by reality, as the increasing attendance and diversity of the audience reflected the change that was underway in the industry.
To put this development into perspective, though, it is necessary to more clearly articulate what is meant by both “mainstreaming” and “sustainable investing.”
A simple and widely used definition of sustainability is taken from a 1987 report on sustainable development prepared for the United Nations by the Brundtland Commission: “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” This definition will sound familiar to investment professionals involved with endowments and families as the concept of intergenerational equity.
The purpose of investing is to apply capital to productive use, addressing opportunities and challenges facing societies and economies, thereby building value over time for the investors supplying that capital. But that value-building economic activity does not take place within a hermetically sealed financial system. Value creation takes place in and depends on environmental, social, and governance systems. It requires the assets and resources those systems provide. Economic activity that is not sustainable degrades those systems, diminishing their future viability and value. Sustainable economic activity maintains or enhances those systems, increasing their future viability and value. The future value of the investment depends heavily on the future state of those systems.
The investment profession has a well-developed language and formal system for measuring and assessing the value created (or destroyed) by financial capital. We use these financial factors and indicators in this work. But we do not yet have a similarly robust system for assessing the value created or destroyed by the use or misuse of environmental, social, and governance (ESG) capital. What we do have is an evolving language of ESG issues, factors, and indicators. The core of sustainable investing is incorporating these ESG issues, factors, and indicators into the investment process.
Viewed through this lens, considering the ESG impacts on future value contributes to fulfilling our mandate as investment professionals. As Erika Karp, the opening speaker at the first Sustainable Investing Seminar in 2013, observed, “Sustainable investing is just investing.”
In the same way, sustainable investors are not that different from other investors. Sustainable investors seek to
• reduce risk,
• obtain alpha (outperformance),
• engage to improve performance of their investments,
• achieve an economic or societal outcome, and
• invest in ways consistent with their values and beliefs.
Reading this list from the bottom up generates the stereotype of the “sustainable” investor. Similarly, reading from the top down generates the stereotype of the “regular” investor. In both cases, the extreme versions of the stereotype would leave out the later items, resulting in the perception that “sustainable” investors are willing to ignore risk and return, whereas “regular” investors don’t care about values or societal outcomes. Both are wrong. Each of these motivations can apply to any investor.
Like all investors, sustainable investors prioritize these motivations and weigh their importance differently. The challenge for sustainable investment professionals is to understand their clients’ motivations and then shape their expectations and investment strategy accordingly. Given this range of motivations and the diversity of ESG systems, it should not be surprising that there are many ways to approach investing sustainably.
Mainstreaming sustainable investing is, therefore, not found as a definitive recipe of three parts “E,” one part “S,” and two parts “G.” Nor is it found in a broad claim of being a “sustainable” or “responsible” investor. Mainstreaming is achieved when ESG issues, factors, tools, and techniques are applied throughout investment practice in support of client requirements.
The 2016 seminar showcased how deeply and broadly ESG issues have reached into the profession of investment management. This research brief, comprising articles written by speakers at the 2016 Sustainable Investing Seminar, showcases the significantly increased activity and innovation taking place and the wide-ranging impact sustainable investing is having on the investment profession.
At the 2015 Sustainable Investing Seminar, Jean Rogers, founder and former CEO of the Sustainable Accounting Standards Board, highlighted new research from George Serafeim, a professor at Harvard Business School. Professor Serafeim’s research showed that firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on such issues. A subsequent paper by Serafeim, published shortly before he spoke at the 2016 seminar, extended that research to shareholder engagement and provided evidence that filing shareholder proposals on material ESG issues was associated with an increase in Tobin’s q. This research is part of the growing body of work collected over the last five years that demonstrates that ESG information is value relevant.
In his article for this brief, Professor Serafeim moves beyond this important but static analysis at the company level to the broader value of ESG information in assessing the impact of transformational changes in the economy. Using mobility as a case study of large-scale transformation driven by technology and climate change, he describes how robust ESG information on material issues will be necessary to understand which organizations will be successful and how to deploy capital in markets.
The amount and complexity of financial data available to analysts soared during the later years of the 20th century. A parallel explosion in information technology enabled the growth in quantitative approaches to investing. The rapid growth in the availability of ESG information in recent years has led to the emergence of quantitative ESG strategies. However, it can be challenging to process such an overwhelming amount of data from both financial and non-financial sources. The relatively higher proportion of qualitative and unstructured data makes the challenge even greater.
Leveraging the power of big data and machine learning to address this opportunity is the subject of Andreas Feiner’s article. Feiner, a founding partner and head of ESG research and advisory at Arabesque Asset Management, describes the development of S-Ray, a tool that aggregates large volumes of sustainability information and applies customizable rules-based analysis on a continuous basis to provide daily snapshots of a company’s sustainability. He provides an example of applying values-neutral, unbiased algorithms to generate performance in a values-based context.
For investment practitioners learning about ESG, the first and dominant narrative is about the impact of ESG factors on companies and stock prices, especially large-cap public equities, although rapid growth in green bonds has brought increased attention to fixed income and ESG. It is not surprising, then, that analyzing the impact of ESG factors is much more common in valuing equities than in valuing fixed-income securities. Going a step beyond that—considering factor impacts for a portfolio of equities and fixed-income securities—is complex even in mainstream financial analysis.
Professor Andreas Hoepner of University College Dublin addresses this issue through the emerging discipline of “financial data science.” Financial data science applies advanced statistical analysis to very large amounts of real-world data. It seeks to use the explanatory power of the data in predicting outcomes to suggest appropriate actions and guide further research. In his article, Professor Hoepner considers the integration of ESG issues into a mixed assets universe, where equity and fixed-income securities are examined in one analytical setting. Which of the dozens of ESG issues perform well in both equity and fixed-income securities, and especially in the mixed setting? The results are surprising, especially with regard to governance issues.
Steve Lydenberg, CFA, a partner at Domini Social Investments, wrapped up the first Sustainable Investing Seminar in 2013 with a discussion of the challenges and opportunities for security analysts as ESG disclosure inevitably becomes universal, based on standardized metrics, and integrated into financial reporting. For more than 30 years, Lydenberg has been a pioneer in sustainable investing, consistently and presciently identifying and tackling the next challenge in the evolution of the field.
In his article, Lydenberg observes how our understanding of risk and the tools to manage it have evolved—from considering the risk of a single security to risk at the portfolio level. He argues that we must now consider system-wide risk.
By complementing the efficient discipline of portfolio management with certain specific intentional actions, investors can manage risks and rewards at these system-related levels, as well as within their portfolios. System-level considerations have the potential to generate a “smart beta” play, with the management of risks and rewards at these levels increasing the performance of whole indexes, as opposed to helping generate increased “alpha” for individual portfolios.
The topics considered in these articles—transformational economic change, quantitative investing, performance of a multi-asset-class portfolio, and systemic risk management as a source of smart beta—demonstrate the ongoing mainstreaming of sustainable investing.
At the same time, each topic builds upon a robust base of ESG concepts that definitively place them within a values-based framework of sustainable investing. Or, to quote Karp once again, “sustainable investing is just investing.”