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Defining ESG Investing and Understanding Its Uses

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Advisors embracing or considering environmental, social and governance focused investing should understand the different definitions used by asset managers, index providers, stock and bond issuers as well as their clients. 

“ESG is not just about values but includes the underlying financial material risks within an industry,” said Mona Naqvi, senior director, ESG, at S&P Dow Jones Indices, who was on a panel about the topic at this week’s Inside ETFs conference in Hollywood, Florida.

Jordan Farris, head of ESG product development at Nuveen, described four different capabilities for ESG: 

  • exclusionary screening of companies based on ethical values, regulations or norm-based violations
  • best-in-class sectors and companies with superior ESG performance relative to their industry
  • climate investment solutions, whereby asset allocation is aligned with the transition to a low-carbon economy
  • ESG integration, which incorporates ESG data into the investment process to improve risk-adjusted returns

Farris scores companies from zero to 10 within each sector, comparing, for example, health care companies to one another rather than to companies in other industries such as energy. 

Morningstar, in contrast, does the opposite in its recently revised ESG ratings, which account for material ESG risk differences between industries as well as between companies within a particular industry. In its new rating system, a tech company ranks higher on the ESG scale than an oil company because of its more limited impact on the environment and is also scored against other companies within the tech sector.

Index providers also differ on ESG scores. Nathalie Wallace, global head of ESG investment strategy at State Street Global Advisors, who was also on the panel, found that the ESG scoring system of two of the largest ESG index providers, MSCI and Sustainalytics, had a correlation of just over half (53.5%). 

“We didn’t know which ones to choose so we looked at what is material for the financial future of companies,” said Wallace, adding that State Street now uses raw data from three rating companies and other data sources to choose the best-in-class ESG data providers.

Financial materiality is at the core of the ESG standards from the Sustainability Accounting Standards Board, which are the foundation of two recently introduced Bloomberg indexes: the Bloomberg SASB ESG equity index for U.S. large-cap stocks and the Bloomberg SASB ESG fixed income index for investment-grade bonds, both marketed by State Street Global Advisors. 

“It’s taking time for people to believe in the ESG story, about three years to buy into ESG strategies,“ said Farris, adding that more companies are also providing ESG data. “Five years ago only about 25% [of the] S&P 500 did, now it’s about 80%.” He expects to see increasing ESG integration in investment portfolios.

“Demand is slowing picking up,” said Sanjay Arya, head of indexes at Morningstar, on another Inside ETFs panel. And performance is impressive. Arya said three-quarters of the 3,000 or so ESG funds in Morningstar’s database have outperformed their traditional benchmarks.

In the European Union, new regulations require financial market participants and advisors to integrate ESG risks and opportunities in their processes, as part of their fiduciary responsibility. 

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