Bottom-up fundamentals-based approaches can allow for deep-dive nuanced analysis of material ESG issues.
Passive ESG: The Data Conundrum
There’s no substitute for nuanced analysis and judgment in ESG investing. In our view, a passive approach to ESG investing that is based on mechanical rules-based implementation of third-party ESG data is fraught with data-quality issues.
The vast majority of ESG data today is unaudited. It is largely based on self-disclosure by companies, which is nonstandard and ranges in level of transparency from company to company. While there have been some attempts in the industry to even the playing field, such as the CDP and Sustainability Accounting Standards Board (which take very different approaches), disclosure is generally far from standardized. For example, only about 25% of U.S.-listed companies disclose all the requested material ESG data, 1 and disclosure rates are even lower in small-cap equities and emerging markets equities. In addition to its lack of standardization, the disclosure also tends to be backward-looking. Companies voluntarily respond to questionnaires from the data providers, typically once a year, using prior-financial-year data. As such, at any point in time, the resulting third-party ESG ratings based on disclosures today could have a 12- to 18-month lag. As active managers, engaging directly with company managements, we come across situations where the ratings and their corresponding explanations may not reflect more recent changes and adjustments in corporate practices. Third-party ESG ratings providers have their own methodologies to take in all the information disclosed by companies and fill in the missing gaps. This process is typically based on top-down assumptions, by sector and then peer group. These approaches can result in unintended consequences
by sometimes missing out on material nuances that are specific to a company’s business model, regional exposure and business mix. In contrast, bottom-up fundamentals-based approaches can allow for deep- dive nuanced analysis of material ESG issues. Such differences can result in very different outcomes, as evidenced by low correlations between third-party ESG ratings providers. While no one would suggest building a portfolio based on credit ratings alone, even where there is a higher level of correlation between ratings providers, it is better than using third-party ESG ratings, which do not offer such confidence on the underlying assessments of material ESG issues. More recently, leading sustainability standard-setting organizations have moved to integrate the disparate sustainability reporting frameworks into a comprehensive reporting system that would include both financial and sustainability disclosure. 2 In addition, evolving data science capabilities offer much progress and opportunity for gleaning additional ESG insights in investment research. However, the evolving frameworks and the enhanced tools to parse ESG data still require nuanced human judgment and deep domain expertise to thoughtfully analyze ESG issues in the context of bottom-up business analysis. For more discussion on passive ESG products, see our publication, Insights: Why Passive ESG Fails to Deliver.
1 SASB, State of Disclosure Report – 2017, data for fiscal 2016. 2 See https://www.sasb.org/about/sasb-and-other-esg-frameworks/.
30 2021 ESG ANNUAL REPORT
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