Constituent policy

Why traditional ESG policy may no longer be enough for investors

Upheaval in Ukraine has forced investors to make urgent changes – but traditional ESG policy may not be enough, writes Annamaria Koerling

Investors started 2022 facing deep uncertainties. Inflation across the world at the highest level in more than 30 years had already destabilized markets, with policymakers feeling pressure to rein in runaway inflation without stifling an already sluggish recovery. Then Russia went to war with Ukraine, and suddenly history was rewritten. Putin’s actions have turned stock market jitters about the trajectory of monetary policy into shivers of dismay at the ramifications of a war that could have profound longer-term global consequences.

The response from the global community has been swift, with governments, the financial sector and corporations taking action, ensuring that this modern, hybrid warfare is fought not only on the ground or in the air, but in the banking system, the energy networks, cyberspace and the media. In the investment world, Russian constituents were removed from indices widely tracked by MSCI and BlackRock, exchanges suspended trading in Russian securities, and Russian foreign debt was downgraded to junk.

How should responsible long-term investors react? The problem of how to mitigate or react in portfolios is not as simple as looking for investments that have direct or indirect exposure to Russia. Investors need to dig deep into supply chains and corporate behaviors to understand who’s walking the talk and not just talking or flaunting.

More complicated still, especially given the necessary acceleration of the energy transition, is the supply of aluminum, nickel, titanium, gold and other raw materials that the United States, the EU and the United Kingdom still buy daily. to Russia. Which companies and governments choose not to sanction themselves and therefore continue to indirectly finance Putin’s warmongering by buying raw materials? For some countries and companies, this will pose an existential threat. Bosnia, Poland, Finland and Slovakia, for example, are almost 100% dependent on Russian gas.

Even before the war in Ukraine, some responsible investors had already reassessed their approach to ESG assessment after an uncomfortable 2021 that saw the valuations of many highly ranked – and, therefore, previously highly valued – ESG stocks plummet. . By focusing on ESG “leaders” (i.e. companies already considered best-in-class in their industry or sector), an investor can very well mitigate short-term risk. However, it may end up paying too much and perhaps also neglecting companies that are making great efforts to improve ESG practices. The new buzzword for these companies is ESG “enhancers”. Investment house Amundi defines these “improvers” as companies that are fundamentally sound and have adopted (or will soon adopt) a positive ESG framework.

To generate alpha and invest responsibly, the thesis is: identify established companies that are at an early stage in their ESG journey or examine companies that are striving to solve seemingly impossible challenges, and you unlock a potentially significant return when their efforts are finally recognized and they are reclassified as the leaders of tomorrow.

American investment house Rockefeller Asset Management has designed an ESG Improver Index that seeks to capture these opportunities. Casey Clark, Global Head of Corporate ESG, says: “We believe investors will increasingly differentiate between ESG Leaders and Improvers – companies with the greatest improvement in their ESG footprint – and the latter offer greater potential for generating uncorrelated alpha over the long term.’ Between a hypothetical portfolio of top-quintile ESG improvers and bottom-quintile “ESG decliners,” improvers have done better by an average of 3.8% per year in an analysis covering US all-cap stocks from 2010 to 2020.

The need for a different approach is supported by research by aon on the unintended consequences of allocating to the best ESG investments. They say a “myopic focus” on investing in a company with high ESG ratings means investors could miss out on “developing a comprehensive approach to mitigating ESG risks”, as well as not fail to identify the opportunities created in a changing global landscape. According to Aon, this is due to three key shortcomings of ESG ratings: “They try to quantify the unquantifiable, they don’t always capture the ‘moving target’ of ESG, and they’re not comprehensive.”

Faced with a very volatile and uncertain situation, it is even more difficult to do the right thing. The waters are still too murky to see through geopolitical angst the secondary consequences and long-term ramifications. While an ESG manager might be too inflexible to respond appropriately to a changing global order, a better approach might be to select an unconstrained, active and thoughtful manager who recognizes that investors want to do good for the planet and its people. inhabitants – but who is servile compliance with outdated ESG criteria can harm your assets.

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