Sustainable investors tend to look for businesses that embody two virtues. The first is a commitment to consider stakeholders, society and the environment in a way that is aligned with long-term, rather than merely short-term, profitability. The second is a sustainable competitive advantage that enables the business to survive multiple cycles and compound its earnings growth over the long term. Most sustainable investors would argue that it is very difficult to find the second without the first.
Sustainable businesses have specific markers relating to these two virtues. Some are relatively easy to quantify, such as a high return on invested capital. Others, such as a strong corporate culture, are less tangible. We believe that analyzing and assessing these less tangible characteristics requires qualitative judgment and close relationships built on long-term shareholder engagement.
In our view, that raises questions about the rising popularity of rules-based, passive sustainable investing products, which mirrors past waves of enthusiasm for market-capitalization, style and factor indices and indexed products. In this paper, we argue that the complex, long-term nature of sustainable investing makes it inherently an active management discipline.
Executive Summary
What Is “Sustainable Investing”?
- A sustainable investment strategy has leadership on material environmental, social and governance (ESG) considerations at the heart of its investment thesis, based on a belief that investing in sustainable business models, practices, products or services can generate outperformance over time.
- The foundations of that belief vary depending on the specifics of each sustainable investment strategy, but one common strategy sees a substantial overlap between sustainability and quality, with strong sustainability characteristics regarded as markers of quality.
Sustainable Investing Requires Fundamental Judgment
- Providers of indices and manufacturers of indexed products have sought to replicate their success with market-capitalization, style and factor index products in the ESG and sustainable investing arena.
- We are skeptical of rules-based approaches to sustainable investing: we believe many ESG and sustainability considerations are intangible and need to be assessed with qualitative judgment; where quantitative data does exist it can be patchy and inconsistent; and ESG scores from different agencies exhibit wide divergence due to idiosyncratic data processing.
- At the very least, we believe investors considering an ESG index product should understand that they will be selecting an ESG index investment product provider, an ESG index provider, an ESG index, and an ESG score provider, and that these decisions should be informed by the same level of due diligence they would apply to selecting an active manager.
Sustainable Investing Requires Engagement and Stewardship
- Index investment product providers may have a team of stewardship professionals, but we believe it is very difficult to engage deeply and constructively with a company without the detailed knowledge and understanding that comes from being a seasoned analyst of the fundamentals of that company and its wider industry.
- Even if an index provider’s stewardship team identify an issue, engage with an issuer’s board and management and reach a conclusion, that conclusion could take months or even years to work its way into reported data, ESG scores and index weighting—and, at worst, it may never do so.
Different ESG Research Companies Award Very Different Scores to the Same Issuers
ESG scores awarded by five companies to 924 issuers, benchmarked against Sustainalytics’ scores for the same issuers
Issuers with the 10 least and 10 most divergent ESG scores from the six ESG research companies
Source: Top: Florian Berg, Julian F. Kölbel, Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings” (April 2022). Bottom: Florian Berg, “Why Do ESG Ratings Vary So Widely—and How Can Investors Make Sense of Them?”, The Wall Street Journal (November 2022). The different rating scales of the six research companies were normalized for comparison, by subtracting the mean and dividing it by its standard deviation.
