Here is a guest article from Federal Street Advisors about how traditional investment managers are looking at environmental, social and governance practices to identify top-performing companies.

How
traditional investment managers are looking at environmental, social and
governance (ESG) practices to identify top-performing companies.

In the
following article, Emily Bannister, director of research, and John LaPann,
chairman and founder of Federal
Street Advisors, examines the issues arising when
investment advisors employ environmental, social and governance practices to
spot top-performing companies. The editors at this publication are pleased to
share these insights but as ever, stress that they do not necessarily endorse
all the views expressed in the article. We invite readers to respond with any
comments.

Over the last 20 years, the social investing industry has grown and
changed.  It has moved from “negative
screening,” such as divesting from South Africa or excluding “sin stocks” from
the portfolio, to a more positive approach that favors good companies and can
even improve companies through shareholder advocacy and lobbying.

Socially responsible investing has also attracted more investors.  According to US SIF (The Forum for
Sustainable and Responsible Investment), SRI assets under management have risen
22 per cent from 2010 through 2012, to $3.74 trillion.  Since 1995, SRI assets have grown faster than
professionally managed assets as a whole (source: USSIF Foundation, 2012).

Whenever an area gains popularity so quickly, there is always the
chance that money managers will offer products just to profit from the trend,
not out of a genuine belief in the approach. 
Unfortunately, we find that there are strategies out there today that
are “greenwashing” – marketing themselves as environmentally friendly when in
fact their ESG criteria are not very strict. 
We also see a number of products being launched that may have good
intentions, but may not have a good, disciplined investment process. 

At Federal Street,
we help clients navigate this landscape, finding managers with strong financial
and social research capabilities.  In the
process, we’ve noticed that many of the evaluation factors that SRI managers
use also provide valuable insight into the overall financial health and
performance of companies.

The broader investment industry is coming around to the same opinion. Without
identifying themselves as “social investors,” many forward-thinking investment
professionals have begun looking at environmental, social, and governance
practices as important factors when evaluating investments. 

For example, they may notice that resource scarcity can create growth
opportunities for companies with solutions to improve efficiency or replace
fossil fuels. They may consider whether a company’s poor record on labor
practices could result in costly disruptions from a strike or regulatory
action, or a consumer boycott. They may question whether a board’s structure
allows it to make the best decisions for all of the company’s stakeholders.

From academics to investment managers to watchdogs, people in all
corners of the investment industry have begun including ESG as a genuine
consideration.  The change has been less
visible than the explosive growth in the SRI industry, but has a larger and
more fundamental impact on capital markets. 

Signs of growth

One indication that ESG factors are being adopted by the broader
investment community is that Michael Porter, creator of the influential
“Porter’s Five Forces” framework used by many traditional stock analysts,
recommends incorporating these factors when assessing the competitive position
of a company.  When Porter highlighted
the need for corporate social responsibility to be considered in the analysis
of competitive advantage, it legitimized ESG analysis for many mainstream
investment professionals.  In a 2011
article, Porter says, “The opportunity to create economic value through
creating societal value will be one of the most powerful forces driving growth
in the global economy.”

In turn, money managers are including these factors as data points
that can help decide whether or not they buy the stock of a particular
company.  Looking at ESG trends can help
investors find areas of growth, identify companies that are cutting costs by
being more efficient, and avoid reputational and economic risks.

There are increasingly high-profile examples of the shift to include
ESG factors as a way to boost returns. Wellington Management, an investment
firm headquartered in Boston,
MA that manages more than $750
billion in client assets, recently acknowledged that ESG factors are
increasingly important to consider when managing portfolios and risk.  Wellington
is a large, traditional investment firm that has developed tools to analyze ESG
information because it believes it can improve the investment process.  To Wellington,
“The motivation for ESG integration is simple: to increase financial returns
while upholding the fiduciary duty to incorporate any known risks into the
investment process.

Other large, well-known asset managers have made similar moves, also
for economically-driven reasons. 
Vanguard and BlackRock have both discussed plans to engage with hundreds
of companies on governance issues.  Pensions & Investments, a leading
industry journal, profiled this effort, interviewing BlackRock’s global head of
corporate governance and responsible investment.  According to the article, “‘BlackRock’s global
corporate governance team is part of the company’s investment function as
opposed to the compliance or legal department,’ Ms Edkins noted.  ‘We think good governance adds value
long-term,’ she added.”

What gets measured gets
done

Many companies now provide an annual corporate sustainability report
as part of their regular reporting package to investors and stakeholders. To
cater to this new demand, accounting firms such as Ernst & Young and
PricewaterhouseCoopers offer services to verify sustainability reporting. A
major data provider to the investment industry, Bloomberg, now tracks and
reports ESG data points for all companies. 
Similarly, index provider MSCI, Inc. now offers ESG research and ratings
on companies.

Now that the watchdogs have started to focus on these metrics,
investors are more easily able to measure and compare companies on issues that
were previously considered “soft.” As more investors track these ESG factors
and make decisions based on them, they become more material to stock prices.

Strong performance and
sustainability often go hand in hand

We have seen for years that investors who incorporate sustainability
into their portfolios have been able to generate strong performance. Some of
this performance is due to the skill of the ESG-focused managers that we work
with, but some is also due to the objective value and advantage that including
this broader set of tools can add.  To
help illustrate this “ESG advantage,” a team of professors at Harvard studied
180 companies from the early 1990s through 2010, splitting the group based on
whether companies voluntarily adopted environmental and social policies, and
found that, “In the 18-year period we studied, the High Sustainability firms dramatically outperformed the Low Sustainability ones in terms of both
stock market and accounting measures.” 

In a world where outperforming the benchmarks is a difficult feat, and
active stock-pickers are always searching for an edge, the strong performance
delivered by  companies with good
environmental, social, and governance practices is reason enough for the lines
between “social investing” and “investing” to blur.

As the investment industry begins to embrace this reality, we keep
looking ahead to find forward-thinking money managers and perspectives to help
our clients achieve their goals.  We believe
that the investment opportunities of tomorrow will continue to be found in
companies that are addressing the opportunities and challenges of the future.  Looking at this future through an ESG lens
can increase the probability of success.