ESG-related mandates and performance

By Leola Ross

While including environmental, social and governance (ESG) data points in the investment process has become tablestakes, ESG factors do have implications for the short- and long-term returns of an investable security. But we believe both ESG goals and performance goals can be reached together.

We believe that ESG factors impact security prices. Therefore, it is the job of investment managers to understand all of the characteristic for every security they hold… or choose not to hold. Environmental, social and governance factors can impact security prices. To ensure the most complete analysis of return opportunities and potential risks,

investment managers should have an understanding of ESG factors. We believe it adds value to a skillful investment process. To that end, we evaluate all active portfolios on their integration of ESG into their investment processes. We have found many managers who integrate ESG very skillfully. Their portfolios are not typically considered ESG portfolios, but on close examination the relevance of ESG to their processes is real and additive.

In many cases, investors want to include or exclude securities because of a specific values-based world view. Alternatively, investors seeking to capture return opportunities are looking at ESG performance. For example, a growth investor may see green energy as a growth opportunity or a restructured governance process as a way to realize a price correction.

These two factors, values and investment value, are different. But either may lead to excluding, and even including, specific securities. Is this two-pronged approach harder than investing for just one goal or the other? Possibly.

We review managers in two ways. In our qualitative review, we examine the incorporation of ESG into the investment process. We find that a small number of managers do this very well. In our

quantitative review, approximately half exhibit above-market ESG metrics. In other words, in looking to outperform their benchmarks, approximately half of the manager universe exhibits above average ESG metrics.

So then, can we deliver an ESG mandate while delivering strong performance? We believe the answer is yes.

A typical mandate we see from our investors is a desire to shrink the carbon footprint of their portfolio – typically by 50%. While trying to achieve the investors’ ESG goals, maintaining investment performance is essential in order to avoid unintended and unrewarded risk. With an intense focus on risk management, we find that lowering the carbon footprint can be achieved with similar performance to equivalent products without the carbon reduction.

In delivering low-carbon portfolios to investors, we find that they track the market very closely. For example, in offering index-based equity products with a 50% carbon reduction, we have observed tracking errors of 0.5%-0.9% and return differences of less than 0.15% annualized. 1 As well, in offering active equity and bond products with a 25% carbon reduction, we have observed tracking errors of 1.3%-1.5% and positive excess returns that are similar to equivalent equity and bond products without a carbon-reduction mandate.

Ultimately, achieving goals such as carbon reduction requires limiting, or even excluding, some portfolio holdings. Investors may wonder if there is a limit on how much excluding is reasonable.

We believe there are available securities, even within the energy sector, that can help reach a goal of lower carbon exposure. And we believe there are managers in virtually every manager universe capable of delivering performance and achieving ESG metrics. But after managers choose their securities, we still need to put those managers together into a unified portfolio. We believe this combined portfolio requires nuanced control at the total-portfolio level. A total-portfolio approach ensures an appropriate overall exposure to a sector like energy and considers the impact of negative screening at the portfolio level – not just at the manager level.

We have also done significant research on both the short-term and long-term impact of negatively screening out ESG hot-button exposures, such as tobacco, munitions, and others. Our research has shown that, if investors are asking for just a small exclusion, like tobacco or cluster munitions – just one or two percent – then that still leaves skilled managers plenty of room to potentially build excess return. We would expect very little impact on excess returns, even in the short term. should have the patience – to take such a long-term approach. It depends greatly on their desired outcome and their appetite for peer-relative risk. How much deviation from peers are asset owners willing to sustain to reach their ESG goals? It is up to the investor and their partners to determine a sustainable level of predictability, even when it comes to responsible, sustainable investing. If an investor desires to exclude 7% of their portfolio, for the good of the planet, but then finds they can’t sustain the unpredictability that comes with such a large exclusion, then the ESG goals may be abandoned and no one wins. «

Source: Russell Investments research

Disclaimer Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

But what if the investor also wants to screen out coal and divest from fossil fuels? What if the sum of total exclusions is as high as 5% or more? At this point, our research has shown some material deviations that are likely to be noticeable in the short term. In addition, shortterm return expectations and tracking error become unreliable and unpredictable. For some investors, this unpredictability will be unacceptable.

However, our long-term return expectations – 10-15 years or more – are still the same. This is a key strategic belief that is core to our investment approach and we believe it is simply basic economics. Every investable company has the same basic challenges of supply and demand, cost structures, return on investment, etcetera. Therefore, skilled managers should be able to find investment opportunities even when a small portion of the universe is unavailable. This results in our strategic belief that no single sector outperforms over the long term.

It is vital to remember that not all investors have the patience – or even

1 Based on funds with less than two years of history.