Behind the curtain of ESG ratings – Wealth Professional

Behind the curtain of ESG ratings Wealth ProfessionalRead More

Wealth Professional

Dynamic Funds’ leaders explain why ESG ratings are not always accurate and why an active approach is important in this space.

By
WPC

Oct 14, 2021

How can advisors and investors be confident in determining company performance according to environmental, social, and governance (ESG criteria) criteria?
It’s complicated. It all depends on who you ask. The same way credit rating agencies might assign different scores to a firm based on different criteria, there can be ambiguity between rating agencies when it comes ranking companies on ESG factors. Firms may get very different scores.
Tesla, the electric vehicle manufacturer, is a great example. Sustainalytics gave Tesla a 30.5 rating1, placing it in the ‘high-risk’ category1. MSCI’s A rating indicates average ESG performance2. S&P placed Tesla in the top quarterile for ESG performance3.

Low correlations
It is not surprising that ESG rating agencies have low correlations. Although rating agencies have a long history in the financial data business, ESG factors are more values-based than numbers. How can you, for example, accurately assess and grade a company’s treatment of employees? It can be more artful than science.
One thing is certain: the stakes are high. A firm that receives a favorable rating from S&P (as Tesla did in May), may have that ranking included in its S&P 500 ESG Index. This index is used by passive ETFs and index funds to build portfolios. This presents a challenge to investors who want to make a difference in a sustainable and socially responsible world. Passive approaches that rely solely on ratings may exclude investments that could have underlying ESG risk and include hidden gems that have strong performance metrics or emerging ESG strength.
Jim Morris, the COO of 1832 Investment Management, who manages Dynamic funds, says that effective measurement of ESG performance requires complex and multifaceted approaches that can be subjective. Dynamic Funds, Morris explains, conducts active ESG assessments of individual companies and leaves the final decision to the investment team.
Morris says that ESG factors have been a key component of our research process for a long time. He is constantly developing in-house ESG infrastructures and risk reporting for Dynamic Funds.
Proprietary active ESG analysis
Dan Yungblut is the head of research at 1832 and a key figure in leading company ESG initiatives. He is also the chair of 1832’s ESG Investment Committee. This committee oversees the integration ESG factors into the investment process. Yungblut emphasizes that Dynamic Funds is a dedicated active manager and relies on its own fundamental ESG analysis.

He says, “If you passively depend on ESG scores I don’t believe you get as much understanding of material ESG elements.” Yungblut says there are two reasons for this. The first is due to the nature of ESG assessment, which by their nature are backward-looking, and capture one moment in time.
Yungblut explains that ESG scores are more static and less focused on future performance. “Active investment managers spend most their time looking ahead, and not behind, when assessing companies futures. This includes ESG criteria.”
Yungblut believes that active managers can gain a more detailed understanding of a company’s ESG profile – now and in the future.
He says that many businesses are well-known and have the ability to determine which ESG-related factors and where the business is heading. “ESG investing is all about experience.
Part of the solution
Another benefit to a legitimately active approach to ESG is that it often yields a better understanding of companies as well as how they perform in terms of ESG factors. It also gives you the chance to be part of the solution to improve their ESG performance. Dynamic can identify companies that may not be leaders in ESG criteria today but are on the way to becoming the leaders of tomorrow by conducting rigorous fundamental research.

Dynamic’s portfolio managers are crucial to this process. They regularly meet with company management, suppliers and employers, as well as other stakeholders. Dynamic’s dialogues with company leaders can help firms identify ESG strength and weaknesses. The team is uniquely placed to influence decisions due to their specialized understanding about the direction and potential growth of the firm. Dynamic may be able to invest earlier in a transformative company, potentially resulting in unrecognized investment possibilities.
Yungblut cites Dynamic’s first ESG-related theme fund, the Dynamic Energy Evolution Fund. This fund is dedicated to finding global opportunities in the transition to more sustainable sources of energy. The fund’s managers spotted an opportunity in a company that is related to solar power. This was due to a lack of reporting on employee training initiatives. Dynamic’s independent analysis revealed a strong company but no material concerns that could have impacted the investment decision.
Yungblut states that Dynamic wants to do its own independent assessment and determine what is going to drive a company ahead before making a decision about whether or not to invest. “We don’t want to outsource our decision making to an external rating company. ESG investing can be complex and relying on only rating agencies may not give the whole picture. Advisors can be a valuable resource to help clients map an ESG journey that will meet their specific goals.

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