Integrating ESG into your existing investment model

Several drivers – including capital flowing into funds that integrate ESG factors and the growing awareness of academic research supporting the benefits – are encouraging more and more investors to practise ESG integration.

Although many organisations are leading the way on this, some investors are struggling with how to integrate ESG into existing investment analysis and models.

To address some of these issues, the Principles for Responsible Investment (PRI) has published a paper, A Practical Guide to ESG Integration for Equity Investing, to provide in-depth guidance and case studies that illustrate advanced integration practices.

The research uncovered a number of interesting findings, one of which is that sell-side analysts respond more positively to discussions about ESG when specific issues are discussed; for example, by referring to a material ESG issue specifically – climate change, water scarcity or cyber risk – rather than referring to ESG in general.  

It also found that many analysts, when looking at risks overall, may already be integrating ESG issues without even knowing it. The sell-side’s production of ESG-integrated research can be motivated by requests and commission-based incentives from the buy-side (asset managers and other investors). For this report, the PRI received nearly 100 pieces of research, highlighting both the demand for ESG-integrated research from the buy-side, and the sell-side’s efforts to meet these demands.

While sell-side and sector analysts express enthusiasm around incorporating ESG factors into their research, the resources allocated to ESG expertise is very limited. This could change – most notably if demand for ESG-integrated research by the buy-side were to increase.

Another important consideration for successful ESG integration is engaging investment managers. The PRI is seeing more rigorous questioning of investment managers on the part of asset owners regarding integration practices. Some of these questions focus on portfolio construction and stock selection decisions, including specific stock and sector examples that demonstrate managers’ integration techniques and reveal their level of responsible investment conviction. Asset owners also like to see investment managers initiate conversations around ESG integration and refer to ESG integration throughout meetings.

Additional questions to ask managers are: What ESG data, research, resources, tools and practices do you use to integrate ESG factors into your investment process, valuations and decisions? What are some specific examples of how ESG factors are incorporated into your investment analysis and decision-making process (for example, asset allocation, definition of the investment universe, portfolio construction, fundamental or sector analysis, stock selection)?

Fully integrating ESG factors into a new or existing investment process takes time and often requires trial and error. Many variables are involved and approaches differ between investment managers and even between teams within managers. The first step, applicable to all investors, is to get senior management to buy in to the benefits of integrating ESG factors into investment processes.

Justin Sloggett is senior manager, listed equity and hedge funds, at the Principles for Responsible Investment