Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
… How ESG ratings providers let the side down
An often-expressed criticism of the ESG investing space, mainly by institutional investors, is the lack of robust benchmarks and/or ratings from independent bodies. ESG investing is complex. A new study by Research Affiliates indicates just how much work the industry needs to do to improve accountability.
The study by Dr Feifi Li and fellow researcher Ari Polychronopoulos, argues that the deficiency with ESG ratings is actually hindering the adoption of those investment strategies more broadly.
Research Affiliates, the California-based investment and research firm, which first promoted the idea of smart-beta strategies with its fundamental, ‘RAFI’, index, concentrates on efficiencies in investment management. The study is called: “What a Difference an ESG Ratings Provider Makes”. It analyses the work of two major ESG ratings firms in the US, against a backdrop of other ESG information providers. Their differences are significant and worrying. The study identified and looked at about 70 ESG ratings providers. The key points are:
- ESG ratings vary markedly by ESG ratings provider because each provider has a unique methodology for assigning company-specific ratings. Investors, therefore, must ensure the approach taken by the ratings provider they rely on is consistent with their ESG preferences or they risk constructing portfolios that do not align with their ESG views.
- ESG portfolios constructed using the ratings of two well-known ESG ratings providers yield large performance dispersion and low correlation of returns. The differences are even greater at the individual ratings level for environmental, social, and governance scores.
- The differences in how ratings providers calculate ESG scores can result in the same company being ranked quite highly by one provider and quite poorly by another. Understanding which metrics are evaluated and how they are assessed is essential to investors selecting stocks that meet the ESG criteria they care about.
The authors note that ESG is a ‘highly heterogenous’ space. Investors, asset managers and ESG ratings firms each have their own preferences about what issues are important and how they should be addressed. The two ‘well-known’ ESG ratings providers analysed closely by the authors are not named in the report.
The subtext, though, is that neither are up to scratch for a new ESG benchmarking system to be used by a big fiduciary fund. Research Affiliates is a lot kinder than that, saying that the different methodologies reflect different values and points of view. As ESG continues to grow in importance, it seems it’s time for the research part of the funds management industry to get its act together.
– G.B.
