Democratizing ESG Data (and why that’s not easy to do)
A growing number of firms in the investment management ecosystem are developing and implementing tools to help investors align their portfolios with environmental, social, and governance (ESG) goals. These goals can be broadly defined as protecting the planet from environmental damage, upholding fair labor and diversity standards, and ensuring governance practices that protect shareholders, prevent corruption, and avoid scandals. From a wealth management perspective, pursuing these goals must be done in the context of providing clients with overall portfolios that are tailored to their needs and offer competitive risk-adjusted returns.
Wealth managers play a critical role in translating ESG priorities into concrete actions for investors. Before diving into how that can be done – and why it is harder to do than one might think – we believe it is fair to address the often unspoken question, “Why does ESG matter?” One obvious answer is that many investors want their portfolios to reflect their values. But that is not the only reason, and from a wealth manager’s fiduciary standpoint, it may not be the most compelling argument in favor of ESG.
In addition to the values-based rationale for “sustainable” investing, ESG issues matter because ignoring them means ignoring risks that can reduce a company’s market share and profitability, and therefore harm its stock price. ESG-related risks can increase operating costs and employee turnover, put off customers, and damage reputations. Ultimately, that hurts investment returns.
Barriers to Informed ESG investing
Embedding “sustainability” information into the investment process can improve risk-adjusted returns. However, this is easier said than done. Even though all types of investors actively seek to incorporate sustainability principles into their portfolio choices, most investment professionals face huge challenges integrating ESG when structuring their clients’ investment portfolios. There are numerous barriers that prevent most wealth managers and financial advisors from actually using ESG data. Why is this so difficult? In a nutshell, ESG data and metrics are:
- Inconsistent and contradictory. Ratings and rankings supplied by the vendors in this space cover different aspects of ESG, emphasize different criteria and often result in wildly divergent views of a given company (more on this below).
- Expensive. The dominant ESG data providers have built lucrative businesses selling data to large institutional investors and are not eager to lower their fees.
- Complicated. ESG data is often difficult to understand and frankly rather useless unless one is an ESG expert. Most financial professionals do not have the time to develop that specialized expertise.
- Difficult to consume. Most investment professionals are not data scientists or programmers. They rely on investment platforms to provide the data they need for decision-making, but most platforms do not offer ESG data (see “Expensive” above).
As a result, most wealth managers and financial advisors are in a quandary. Their clients want to incorporate sustainability into their investment portfolios; however, without access to good, defensible, usable ESG data at an affordable price, the alternative is to use mutual funds and/or ETFs that claim to focus on “green” or “sustainable” investing and hope for the best.
There are many problems with a “hope for the best” approach:
- A lack of objective standards or accountability in terms of what defines “green” or “sustainable” in the mutual fund/ETF arena. A fund’s ESG claims might be valid (whatever that means), or mostly clever marketing;
- A fund that is ESG-driven may not offer the risk characteristics or diversification profile that suits the needs of a wealth manager’s clients;
- It is difficult for a wealth manager to objectively choose among ESG-oriented funds without some way to make an apples-to-apples comparison of funds with respect to their ESG characteristics.
Also essential to note: Every company is exposed to ESG risks, so every mutual fund and ETF has an ESG “profile”, even those that do not have a sustainability mandate. Many funds hold stocks that are among the leaders in their sectors in terms of environmental (or social or governance) practices, but they are not labeled as “ESG funds”. In contrast, some funds that explicitly focus on being “green” may hold stocks that do well on certain measures of environmental practices but not others, or they may have less than stellar labor practices or a questionable track record in terms of governance. In other words, not all “sustainable” funds are as good as they claim to be, and certain funds that make no claims about ESG may actually be more “sustainable” than some that do.
Rather than relying on a mutual fund or an ETF’s claims about its ESG credentials, wealth managers could make better-informed choices for their clients by using objective, third-party ESG data or scores. This is a good idea, but one that opens up Pandora’s box of issues.
ESG data – no rules, no consistency
A good number of firms offer ratings or scores related to ESG (and some focus only on “E”). However, the data behind those ratings is subjective because companies self-report their sustainability practices (or choose not to issue a report), and there is no definition of materiality with respect to those practices.
That means every ESG ratings firm has to decide which data to use, and how to combine the data into E, S, and G ratings. Each firm must make ethical judgments about what matters most within the individual E, S, and G categories, and for a given industry. As a result, ratings are often wildly inconsistent across providers – a company can receive high, medium, and low scores across different rating firms – and by selecting any single provider’s ratings, end-users are relying on only opinion among many.
The Wisdom of the Crowd
One vendor, OWL Analytics, takes a unique approach to solving this problem. OWL derives “Consensus Scores” by combining hundreds of ESG data inputs across a large number of sources (from generalists to specialists to public entities) that represent a wide range of perspectives. Rather than choosing one source as the “authority”, the Consensus Scores adopt a “wisdom of the crowd” approach, leveraging the world’s leading ESG data and research firms’ insights.
OWL analyzes each provider’s ratings to determine which underlying metrics were chosen as most relevant for a given industry. Behind the scenes, OWL uses over one hundred metrics to capture the way the range of ESG data vendors construct their ratings. From this, they construct a broad-based, unbiased, consensus view of the relevance of various E, S, and G metrics for each industry.
Creating value for clients with ESG Data
First Rate gives wealth managers access to OWL’s Consensus Scores for mutual funds, ETFs, and individual stocks. Wealth managers can use the Consensus Scores to make unbiased recommendations concerning ways to improve, the sustainability of their clients’ portfolios in the context of the client’s overall objectives for risk, diversification, and style preferences. With OWL’s Consensus Scores, wealth managers can evaluate how modifying weights among the funds a client holds or how replacing Fund A with Fund B would affect the client’s overall ESG profile, as well as the portfolio’s risk and style characteristics.
Consensus Scores give advisors and wealth managers the information they need to provide a truly informed respond when a client suggests adding a “green” fund to the mix. Rather than simply adding a fund based largely on its marketing message, a wealth manager can add real value using OWL’s data to compare ESG characteristics across funds (whether explicitly “green” or not) and create customized solutions by choosing funds that meet each client’s risk, diversification, style, and sustainable investing goals. It is also a way for wealth managers to deepen relationships by educating clients about the ESG space.
First Rate uses OWL’s Consensus Scores to derive our Blue Chip Sustainability Fund Rankings. We invite you to learn more about the Blue Chip Fund rankings and read our research reports for additional insights.
Ben Webster is the CEO at OWL Analytics, a provider of financial data, research, and indexes whose mission is to make the world a better place by helping clients integrate alternative data sets like environmental, social, and governance (ESG) data, into their investment strategies for increased sustainability and performance. Mr. Webster heads sales, operations, and product development for the company.