ESG: A natural dimension of quality

18/10/18

Top ESG ratings for Quality strategies

More and more investors expect their investments to be managed sustainably. Sustainable investment used to be something of a niche market that often involved value-based thinking, but many investors – especially institutionals – are starting to realize that sustainability can also be beneficial from a return perspective. They pay attention to environmental, social, and governance (ESG) factors because they acknowledge that unsustainable business practices give rise to operational risks that can have a negative impact on a company’s bottom line. This is especially true for investors with a long-term horizon such as pension funds, churches, insurers, etc.

This realization is nothing new for Quality investors. They know from experience that a company needs to be economically sustainable if it is to employ sustainable business practices. Indeed, Hérens Quality Asset Management has always believed that a company failing to operate sustainably in its own right cannot contribute to the sustainability of the system as a whole. For some time now, it has been possible to track this using sustainability and ESG rankings.

Fig. 1 shows the Morningstar Sustainability Ratings for CEAMS Quality equity funds. These are a measure of how well the companies in a portfolio manage their risks in relation to ESG factors, and they therefore make it possible to compare funds from an ESG perspective. The results show that CEAMS Quality equity strategies achieve top ratings and rank among the top 10% in their category for Europe, the USA, and emerging markets.

Quelle: Morningstar

Fig. 1 Morningstar Sustainability Ratings for CEAMS Quality equity funds as of June 30, 2018

Quality as an investment strategy with integrated ESG approach

The high ESG ratings of Quality strategies show that the Quality investment style is a sustainable investment approach in itself. It belongs to the group of strategies featuring an integrated ESG approach in which ESG factors are systematically and explicitly included in the analysis.

Fig. 2: Volumes in ESG/SRI investments by approach and region

Source: GSIA, Report 2016

Fig. 2 shows that by far the most common sustainability approach globally is negative screening, followed by investment strategies with an integrated ESG approach, value-based SRI overlays, and engagement. The Quality approach employed by Hérens Quality Asset Management is all about sustainable profitability. ESG factors are included in the analysis along with key metrics for financial strength, market position, and other aspects. Governance – the G in ESG – is an especially critical aspect in the Quality approach. Experience also shows that good environmental and social practices correlate strongly with good governance.

Governance: the most important factor in ESG analysis and a source of alpha

A company’s governance is often the most important starting point for ESG analysis and also constitutes the interface to economic Quality analysis. Analyzing governance structures offers an insight into the overall quality of a company’s management. Good governance adds value for investors in two respects: it helps them to avoid companies that will fail through weak governance, and companies with good governance often have above-average financial results and ESG ratings (see also Monthly Investment Insights of May 2018 and October 2017).

Quality portfolios are sustainable portfolios

Quality companies are generally also able to meet ESG goals. They care about maintaining their reputation and cannot afford to have it damaged by ecological, social or ethical misconduct. They publish detailed and meaningful annual reports containing statements on their ecological, social, and ethical achievements. Hérens Quality AM checks these reports, asks questions where necessary, and allows these sustainability considerations to flow into its buying and selling decisions.

Where clients have individual requirements concerning the exclusion of sectors or companies that are (in their view) ethically problematic and/or wish to invest in line with specific themes, Hérens Quality can support them with in-house research. The Quality approach with integrated ESG can thus be augmented with additional components at any time.

Fig. 3: Hérens Quality approach with regard to sustainability

Source: Hérens Quality AM

Third-party blacklists can also be taken into account. Experience of using blacklists from renowned ESG research providers including ISS-oekom, Sustainalytics, Inrate, and MSCI for our clients shows that it has no noticeable effect on the performance and risk characteristics of a Quality mandate (with the exception of Quality Switzerland). As a rule, less than 5% of the fund volume is affected by third-party blacklists. This result is not surprising as investment strategies with an integrated ESG approach yield similar results to negative screening approaches.

Background of ESG ratings

In the past, it was difficult for investors to compare different funds on the basis of sustainability criteria. Those who wanted to invest sustainably were restricted to a relatively small group of products that bore some kind of sustainability label. These products, also known as socially responsible investment or SRI funds, often pursue strategies that are based either on exclusion criteria or on an activist approach in which the fund management exerts pressure on companies to adopt more sustainable business practices. There are a number of problems with this. First of all, there are not many products of this kind. Only 2% of the funds in Morningstar’s fund universe, for example, make any claim to sustainability. A further difficulty lies in the fact that funds are labeled as SRI products by the providers themselves, so it is hard for investors to verify the extent to which sustainability criteria are in fact applied (see J. Hale, “Introducing the Morningstar Sustainability Rating for funds”).

Rating agencies and research firms including Morningstar, Sustainalytics, Reuters, MSCI, Inrate, and ISS-oekom have closed this gap in recent years by developing ESG rankings for companies and funds that are intended to make direct comparisons possible. This increased transparency translates into a larger universe of investable strategies for ESG and SRI investors.

Conclusion

Quality is definitely an attractive option for investors who are looking for sustainable strategies. The excellent sustainability ratings awarded to our Quality strategies prove that there is a close correlation between sustainability in the ESG sense and sustainability in the economic sense.

The average ESG rating of the equity fund CEAMS Quality Switzerland can be explained primarily in terms of the portfolio’s construction: whereas most Swiss equity funds use stock weightings that are heavily influenced by the Swiss Performance Index (SPI), the three largest constituents of which – Nestlé, Novartis, and Roche – alone account for approximately 60% of the index, the stocks in the Quality Switzerland portfolio are equally weighted (as far as liquidity allows). This makes for a smaller allocation to large caps and a larger allocation to small and mid caps. As a rule, smaller companies achieve lower ESG ratings because their ESG documentation is less comprehensive.

MONTHLY TOPIC ESG: A NATURAL DIMENSION OF QUALITY

 

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