Steve, in the first part of our conversation you made a distinction between negative screening, ESG investing and impact investing, as separate approaches. Let’s take a closer look at ESG investing. You defined it as strategies “where Environmental, Social and Governance factors are incorporated into investment decisions, with a view toward improving investment outcomes by being more holistic.” That sounds pretty broad, so can you give us a better sense of what that covers?

Within ESG investing there is a basic distinction, you could even say a bifurcation in the marketplace, to keep in mind. On one side you have investment strategies where some form of ESG integration has been applied. On the other, there are sustainability-focused strategies that are more explicitly marketed as such and typically go deeper. The newly released US SIF 2018 trends report reveals that there are about $12 trillion of professionally managed assets in the US that follow sustainable, responsible and impact investing principles. However, when you look at the composition of this figure, the vast majority is following ESG integration, whereas only a small portion represents sustainability-focused strategies.

So, what does the bulk of these assets that are practicing ESG integration represent?

I like to think of it as the next wave of upgrades in portfolio risk management. Portfolio management practices were upgraded in the 80s and 90s to include tools of quantitative finance. This was portfolio risk management 1.0. In contrast, ESG integration, i.e. the integration of non-financial information, represents portfolio risk management 2.0.

There is a range of ways this is done. The key is to have a systematic approach to incorporating ESG aspects into investment decisions, rather than leaving it to the discretion of analysts and portfolio managers. Different asset management firms will put different emphasis on ESG factors relative to other investment considerations (e.g. valuation, momentum etc). Some have a strong focus on ESG risks, you could call it high “ESG risk aversion”, and will place considerable weight on ESG. For others, while ESG aspects are considered, they don’t influence decisions to a significant extent.

A critical driver of the growth in in ESG integration is demand from institutional asset owners, in particular in Europe. Asset managers often embark on firm-wide ESG integration efforts, in the context of signing the UN Principles for Responsible Investment.

When some observers claim that in a few years, all investments will be sustainable investments, they are essentially saying that tools of ESG integration will become the norm, just like quantitative portfolio risk management is part of any investment process.

How does this differ from more sustainability-focused investment strategies?

Investment strategies that are marketed as sustainable typically go further in incorporating ESG considerations. Within listed equities, for instance, typical approaches include positive ESG screening (portfolios consisting of better rated issuers based on some ESG scoring system), ESG tilting (portfolio weights are adjusted to favor issuers with higher ESG scores, but without necessarily excluding those with low scores), and sustainability-themed strategies that include, for example, companies with significant revenues from areas such as clean energy, water infrastructure, sustainable food, education, healthcare and many others. Shareholder engagementaimed at improving issuers’ behavior and practices in key ESG areas often complements these strategies.

In my experience, variations on these approaches are what can most credibly be marketed to individual investors through the wealth management channel as sustainable investment solutions. In contrast, lighter-touch ESG integration approaches are often difficult for individual investors to understand and tend to fail their “sustainability smell test”.

The UN Sustainable Development Goals, or SDGs, have become very topical in the Sustainable Investing community this year. How do you view the SDGs from an investment perspective?

It is encouraging that the investment community has now embraced the SDGs. It makes it more likely that private capital sources will be able to contribute to solving key environmental, social and development problems. However, the SDGs were not designed as an investment framework and the reliance on their terminology has the potential to create considerable confusion. For this reason, I think it’s helpful to consider two different perspectives.

The first is a risk perspective. Under this angle, progress toward the seventeen SDGs and the 169 underlying targets can shed light on the ESG risks of investments into countries and companies. Understanding the achievement gap but also tracking the momentum in closing the gap toward individual targets can provide insights into country risk that is complementary to many traditional factors.

The second is the impact investing perspective. The SDGs can be viewed as a menu of potential impact areas. So far, most investors who have adopted the SDGs as part of their framework have conducted a mapping of their investment areas onto the SDGs or targets. There are many superficial examples, but also some very thorough approaches such as the APG — PGGM Sustainable Development Investments typology. However, by and large, these are static frameworks. If investments remain the same from year to year, so will the mapping onto the SDGs. Clearly, what is missing is incorporating the same type of achievement gap analysis that was referred to above when discussing risk. Understanding the extent to which an investment portfolio is not only supporting the SDGs but also focusing on those areas where the gaps are the most apparent, should be a useful perspective for any impact investor.

How easy is it to serve the sustainable investing needs of clients at different wealth levels, and what should wealth management firms consider when developing their platforms?

This touches on a common challenge for wealth management organizations, namely determining how much customization to offer to clients and how much standardization is beneficial. The ability and willingness to customize naturally increases for higher asset levels. The difficulty is that sustainable investing requires a greater degree of customization than traditional investments. This is because there are multiple types of non-financial preferences that clients can care about, ranging from areas that should be screened out of portfolios to a wide array of thematic preferences, or the degree of positive impact that a portfolio should seek to achieve. While in the ultra-high net worth space, customization is expected, for the core affluent segment, finding scalable ways to offer customization (mass customization) rather than one-size-fits-all solutions will be a critical challenge for wealth management firms involved in sustainable investing in coming years.

One of the most hotly debated questions of ESG investing is whether ESG investments have a better, equal or worse risk-return characteristic than “normal” investments. Has the market underpriced ESG risks in the past? Do we actually have good enough data quality to make such statements at all?

There is abundant empirical evidence, accumulated over several decades, showing that incorporating ESG aspects into investments is at least neutral regarding its impact on financial performance. Besides individual studies, there have been various meta-studies as well, including a very comprehensive and prominent one by Friede, Busch and Bassen in 2015: ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies. After combining the results of over 2000 individual studies, the authors conclude that approximately 90% of studies find a nonnegative relation between firm ESG characteristics and corporate financial performance. For studies focusing on investment performance at the portfolio level, the large majority found a neutral or mixed result regarding the link with ESG characteristics. Those latter conclusions, by the way, are fully in line with a smaller meta-study I conducted while at UBS (you can find it here).

A difficulty with most of these studies is that they do not do a good job of distinguishing between approaches to sustainable investing. So it is difficult to draw general conclusions. However, I’m quite comfortable with the statement that ESG investing, while not necessarily leading to better performance, can be a potential source of alpha if done well. Looking forward, it is likely that ESG factors will be more broadly incorporate by most asset managers. Those who will succeed in adding value with ESG analysis are those that take a differentiated approach, often digging deeper into ESG issues, rather than replicating some consensus. That’s the way things work for active management outside of ESG as well.

Do you see a risk that financial service providers are over-promising on the financial and non-financial returns? Based on our conversation, it seems to me that proper accountability is one of the key requirements for ESG investing and its success in the long-term.

Claims about financial performance should always be taken with a lump of salt, whether they are ESG-related or not. With regard to non-financial impacts (e.g. on society or the environment), there needs to be greater transparency regarding what different sustainable investment strategies are intended to deliver.

Steve, we touched on many aspects of ESG investing. What will you focus on from a research perspective in the coming weeks and secondly, how will you improve your own ESG portfolio further?

Personally, I think that understanding what big data and AI can do to improve ESG integration will become an increasingly topical research question. In a brand new paper, George Serafeim from Harvard Business School shows that traditional ESG can be combined with ESG signal derived with big data techniques in a way that is complementary and adds value to portfolios.

As far as my own investments into ESG solutions are concerned, I will be focusing on features such as shareholder engagement and on impact reporting.

Thank you Steve for taking the time. It was a pleasure exploring the topic with you and I look forward to our continued collaboration.

Note to readers: Steve is advising CountryRisk.io and SWISS FIN LAB on ESG investing, client risk profiling, and on in integrating ESG and SDG aspects into country risk analysis. If you are interested in a collaboration on such topics, please reach out to me or Steve.