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An End-to-End Guide to ESG in Asset Management

The ESG pressure is growing on asset managers. We outline what’s driving this, the ESG challenges they face & how to integrate ESG into asset management.

Asset managers are increasingly being tasked with incorporating environmental, social and governance (ESG) factors into their investments and assets under management (AuM). ESG is the requirement to ensure that investments are ethical, sustainable and don’t fall foul of regulation – all vitally important from both a moral and business standpoint.

The pressure to incorporate ESG factors into investment strategies is being felt across the entire financial world. Portfolio and wealth managers, as well as investment funds and firms, are all subject to increased scrutiny on the rigours of their approaches to ESG investments.

In this article, we’ll focus on the asset management world. We’ll overview why the ESG asset management landscape is so tightly wound at this moment in time, look at the common challenges asset managers face around ESG factors – as well as solutions to these – and lay out a comprehensive guide to integrating ESG into asset management.

We’ll also link to other articles in our ESG series, and for those with a clear idea of what they want to dive into, you can jump to the sections here:

The growth of ESG within assets under management

There is no hiding the fact that ESG-driven AuM is exploding.

Recent findings from PWC predict that ESG-orientated AuM will reach $33.9 trillion by 2026, outstripping investments in other categories. Meanwhile, 8 out of 10 in the US-based asset managers expect to expand their allocations in ESG products within the next two years. So what’s driving this rapid expansion of ESG focus?

Regulatory Pressure

Regulatory bodies worldwide are turning the screw on what kind of checks and protocols should be applied to investments. This is due to widespread concern that funds may often engage in ‘greenwashing’ – playing up the ESG credentials of investments to those whose assets they are managing. In turn, similar questions are being asked of businesses themselves and the rigour applied to how they present their credentials in this area.

The European Commission’s Sustainable Finance Disclosure Regulation applied across the EU is a key example of this. The SFDR has already had two levels of ESG regulation in place, which started in March 2021. A note of importance: these are applied to companies and products both with explicit ESG claims – and those without. For European-focused asset managers, these regulations have proven a tough path to meet, with changes often introduced quickly and a dearth of quality data available to prove compliance.

Europe isn’t the only territory focusing on ESG regulation. The US Securities and Exchange commission (SEC) now requires extensive carbon emission reporting from asset managers. Further bodies such as Financial Conduct Authority, Competition & Markets Authority, Advertising Standards Authority and the Task Force for Climate Related Disclosures (TCFD) are all focusing on increased regulation on ESG assets.

Shifting investor priorities

There is an increasing shift in the attitudes of both investment funds and private investors towards a more responsible investment landscape. There are funds set up to impact invest and invest ethically along thematic lines in order to make a difference.

But the majority of the shift towards ESG-integrated investments lies with ESG as a marker against financial returns. Prioritising ESG means that asset managers stand the best chance to avoid the associated risks that come from falling foul against these measures. A company that disregards an important ESG aspect may well find themselves subject to sanctions, lawsuits and heavy economical impact.

The focus from investors increasingly is to incorporate ESG to avoid these issues and lessen the risk that their funds may take a hit.

The rise of responsibly-focused thematic investing and impact investment highlights these changing attitudes. A positive return on assets is still the main priority, but ethical investments too are on the rise.

With both regulatory and investor scrutiny on ESG, it’s clear that asset managers need to enhance and overhaul the way they integrate it into their decisions. But there are a common suite of issues that must be tackled to begin with.

ESG challenges for asset managers

Despite the fact that ESG factors are now firmly established as priorities within asset management, there are still a number of ESG challenges for asset managers that are hampering the industry’s approach as a whole.

The first point to consider is that regulation is fluid; it varies from body to body, across geographies and is consistently updated. Tackling this requires two key steps: keeping up with the varied stipulation asset managers are subject to, and ensuring the data needed for them is accessible and available.

This data accessibility is a major challenge in the ESG space. Firstly, data that shows there may be a problem within an organisation’s ESG factors can be hard to come by; companies aren’t in the habit of releasing information that paints them in a bad light.

Another key issue that has powered much of the ESG regulation in play is greenwashing. This is where a company releases deliberately misleading or cherry-picked data to give the impression of having better ecological credentials than they actually do. Think of a company that boasts of renewable energy powering their distribution centres, whilst relying heavily on fossil fuels in their production facilities. It needs careful checking by experienced ESG researchers to sometimes uncover this kind of misleading tactic.

That’s why many turn to using ESG research specialists for their investigations, as opposed to doing the work internally. These specialists are diligent and can provide a more in-depth view for their clients – but the downside is the risk of outside expertise as an external factor, alongside in-house asset management expertise. Additionally, external specialists often utilise ‘black box’ data and methods that are kept in-house as their USP. This means that their outside influence is reduced simply to results and there is no education or experience gained by your internal team to take forward.

Looking at the ESG industry as a whole presents another challenge for asset managers – ESG rating agencies and researchers all have a different viewpoint on the data they receive. Because levels and ratings of ESG are non-standard and have an enormous amount of variety globally, what could receive a ‘green’ rating in the eye of one ESG organisation may actually be flagged as less-positive by another.

ESG screening is a broader (and faster) method of narrowing down investment opportunities based on ESG criteria. Fund screeners, norm-based screening and exclusionary screening are all different ways that asset managers can set the criteria important to them, and then screen in/out businesses based on these.

Screening gives a clear, structured way to approach ESG – initially. But the approach tends to be extremely broad; getting rid of industries that are unethical or businesses that don’t reach international standards is a great first step. But a first step is all it is. To uncover innovative, alpha-driving opportunities, asset managers will have to do subsequent ESG analysis to a greater degree once they have screened.

Profitability vs. ESG

A final challenge that is thankfully becoming less of an issue in an aware and balanced investment landscape is profitability vs ESG for asset managers.

There is a discussion to be had that industries that fall foul of ESG criteria (firearms and gambling as two examples) are extremely profitable, and that by removing them from your pool of potential investments you will see a reduced return on your allocated funds.

Concerns also circle the cost implications of a company that have strict, high-quality ESG mandates in place. An example being a company that uses renewable energy and seeks to avoid any environmental impact on where it is based will have higher costs and not be as efficient as others.

There is no consensus on whether ESG investment outperforms a more traditional approach – some studies show it does, others that it can hamper performance. But it is widely accepted that investing in ESG-positive opportunities does lead to an improvement in investment safety. If a company isn’t staring down the barrel of a regulatory (or even societal) reckoning due to poor ESG practices, then it is less likely to see a fall in share price and cause issues for investors.

ESG integration in asset management: how is it done?

Any investment research or screening isn’t an exact science, as the results, interpretations and regulation aren’t either. But there is a clear set of best practices that can give asset managers the guidance they need to tackle a complex, wide ranging issue.

Set out your baseline: To begin with, there are vital due diligence decisions to make. Are you going to implement ESG benchmarking and analysis on a fund by fund basis, or across the whole firm? Are you going to rely on ESG screening to carry this out, or the more in-depth (and challenging) ESG integrated investing process? Getting your ESG policy right is essential.

Initial screening can help: As mentioned previously, screening won’t take you all the way to the companies you wish to invest in, but it can cut large swathes of unsuitable candidates out of the market. Set some parameters of industries to avoid, and ESG issues that are important to you, and screen these to narrow the playing field.

Identify key research factors: Before you delve into ESG research, you need to work out what is important to you, and use these as your filters. Are you focusing on environmental impact? Does a transparent pay structure and equal opportunity measures rank highly? Do you only want to look into businesses that have a dedicated ESG taskforce to hold all activities to account? The topics are multiple under each aspect, so you need a consensus on the handful that matter most to focus on.

Apply these factors carefully: Are you going to eliminate the lowest performers against your chosen criteria? Or only select the handful that are setting the benchmark? Working out how to apply your ESG to potential investments brings clarity to proceedings. Also consider factors in play outside of where they are usually found. For example, are you applying renewable energy usage not to energy companies themselves, but instead to food manufacturers? Remember that almost all areas of ESG can and will impact a wide range of industries.

Leverage smart technology: The million dollar challenge. The more thorough and detailed your ESG research, the more money, time and resource it takes up. Or at least it used to follow that equation. There are technologies now that can automate and refine ESG research to a needlepoint, and do so in a fraction of the time it would take a researcher to do.

That’s CID’s area of expertise, provided by our Thematic Intelligence solution, Affinity.

Affinity uses AI and an enormous data set to tap into a global pool of clearly defined and relevant companies according to your key ESG drivers that you have selected.

Affinity’s tailored, thematic approach means asset managers deepen their understanding of ESG factors by accessing unstructured data sources that far outstrip the abilities of traditional providers. Quantitative data sources are combined with financial reports, publicly available meeting notes, call records and news sources for a deeper understanding.

The tool and its rule sets can then be tweaked, refined and pivoted in order to deliver a bespoke set of thematic ESG data.

The result? The ability to focus on the precise ESG factors that are important to your investors, without compromising your time and resources that are needed to actively manage assets and invest.

To learn how to prioritise and enhance ESG compliance, transparency and performance within asset management, our ESG research page is where to start. Or maybe it’s time we talked.

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