ESG is a growing theme across the world. Rather than being a consideration that limits an investment universe or portfolio manager’s process, ESG can be thought of as an additional screen to consider when making an investment as it can often provide a layer of risk mitigation.

In brief

Considering ESG as part of an investment strategy need not cost investors returns, and may even improve risk-adjusted returns in some cases. While sustainable investing is a broad term that can mean different things to different people, it is becoming an increasingly important consideration across investor groups and asset classes.

Environmental, social and governance (ESG) topics can be part of broader investment goals, or a specific requirement. Investment strategies that consider ESG can be aligned with client objectives in different ways.

As our “Guide to the Markets – UK report” shows, considering ESG as part of an investment strategy need not cost investors returns, and may even improve risk-adjusted returns in some cases.

What are E, S and G?

Environmental

Issues relating to the quality and functioning of the natural environment and natural systems, such as carbon emissions, environmental regulations, water stress and waste.

Social

Issues relating to the rights, well-being and interests of people and communities, such as labour management, health & safety and product safety.

Governance

Issues relating to the management and oversight of companies and other investee entities, such as board composition, ownership, shareholder rights and pay.

Types of sustainable investing

ESG integration

ESG integration is the systematic and explicit consideration of ESG factors in the investment decision-making process. Often, portfolio managers can ascertain details about a company’s plans for the future, resiliency, and business practices by asking direct questions, through in-depth research, or active engagement, which can feed into the investment decision.

ESG integration does not limit the investment universe or exclude sectors or companies unless required by client guidelines or local regulations. Investment teams consider the idiosyncrasies of each strategy in their development and approach to ESG. These considerations can provide an additional layer of risk mitigation that could lead to increased risk-adjusted returns.

For example, ESG integration can help an investor avoid buying securities of a manufacturing company that fails to adequately prepare for resource shortages that impact longer-term business viability. Or it can help a portfolio manager choose a company that screens positively on privacy and data security concerns versus other companies that may face challenges in that realm.

Best in class

Best in class, or positive screening, actively seeks to invest in those companies with positive ESG performance relative to peers. For example, if a business has adequate planning for future environmental regulation and policy initiatives due to out-of-favour or climate-disruptive sources of energy, it may be selected as “best in class” compared to others in the sector.

Another example of a best in class company is one where the compensation of senior management is well aligned with long- term company viability, or where the board of the company is diverse and independent versus peers. Like ESG integration, best in class screening does not always limit the investment universe.

Values/norms-based screen

Screening avoids certain companies or industries that do not align with investor values or meet their norms or standards. For example, certain investors may have hard rules on excluding tobacco, nuclear power, weapons, alcohol and gambling or other industries. Others may wish to exclude companies which breach an international standard on human rights.

The selection of exclusionary investment strategies is evolving to meet investor demand.

Impact/thematic investing

Thematic investments are those that are based on specific environmental or social themes or assets related to sustainability, such as green bonds, public services bonds and private equity in enterprises that have social objectives. For example, a strategy dedicated to alternative energy or low carbon investments would be classified as an environmentally focused fund.

Our “Guide to the Markets – UK report” shows MSCI ACWI ESG Leaders, a capitalisation- weighted price index that provides exposure to companies with high ESG rankings relative to their sector peers and excludes companies with involvement in alcohol, gambling, tobacco, nuclear power and weapons.

ESG rankings are given to companies based on the MSCI framework. The MSCI ESG Leaders Index aims to target the sector weights of the underlying indices.

Relative to the MSCI ACWI, the MSCI ACWI ESG Leaders Index outperforms since inception of the ESG index. However, this is just one example of combined “best in class” and norms- based screen from one data provider. There are many types of third- party ESG screening and rankings. Notably, this index outperforms the MSCI ACWI in periods of drawdown.

Exhibit 1: Global Central Bank Policy

Source: MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. Both MSCI ACWI and MSCI ACWI ESG Leaders are in USD, rebased to 100 at the inception of the ESG Leaders index. MSCI ACWI ESG Leaders is a capitalisation-weighted price index that provides exposure to companies with high Environmental, Social and Governance (ESG) rankings relative to their sector peers and excludes companies with involvement in alcohol, gambling, tobacco, nuclear power and weapons. ESG rankings are given to companies based on the MSCI framework. The MSCI ESG Leaders index aims to target the sector weights of the underlying indices to limit systematic risk introduced by the ESG selection process. Past performance is not a reliable indicator of current and future results. Guide to the Markets – UK. Data as of 30 September 2018.

Investment implications

ESG can apply across asset classes and types of strategy, and need not cost an investor returns. Rather than being a consideration that limits an investment universe or portfolio manager’s process, ESG can be thought of as an additional screen to consider when making an investment as it can often provide a layer of risk mitigation. This can potentially lead to sustainable stronger risk-adjusted returns.

Nandini Ramakrishnan, Global Market Strategist, JP Morgan

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