Cerulli Analysts Tackle Tough Topic of ESG ‘Materiality’

The latest update of Cerulli Associates’ U.S. Monthly Product Trends report tackles the evolving topic of environmental, social and governance (ESG) investing programs, taking a close look at how performance metrics stack up against high hopes for the asset class.

According to Cerulli researchers, one of the biggest hurdles in turning ESG interest into actual investment, both by current users of ESG portfolios and non-users, is the perceived impact on investment performance.

“Among ESG users, only 19% state that sustainable investment returns are a major factor driving their demand for ESG,” the report says. “On the opposite side of the fence, 35% of advisers not currently using ESG note that a negative impact on investment performance is a significant factor preventing them from implementing ESG.”

Given that individual and institutional investors are exploring the topic with greater interest, asset managers have prioritized incorporating ESG factors into their investment processes. This is a positive step for the development of ESG, Cerulli researchers explain, but more importantly, conversations with distribution partners have not necessarily led to actual investment among financial advisers and their institutional or individual clients.

Cerulli’s research argues that “true ESG integration” requires the application of material ESG factors “with intentionality,” in a process driven by actionable and robust data that is aggregated from both proprietary and third-party sources. U.S. equity and international/global equity are among the most common product development initiatives in the ESG domain, which Cerulli says is likely a result of the greater availability of data for securities that constitute the strategies in those asset classes.

“Should asset managers begin to prove out that products integrating ESG factors into the investment process can not only provide comparable returns to those that do not, but in some cases, outperform, it will be a big step in breaking into the non-user cohort,” the report says.

A deep dive into ‘materiality’

The Cerulli report goes on to explore in some depth the term “materiality,” and what it means to various stakeholders in the ESG discussion.

“While not a new concept, materiality is essential to efficiently integrating ESG factors into the investment process,” the report states. “It boils down to being able to determine which ESG factors are likely to be linked to stronger investment performance by identifying risks that are related to certain industries.”

The Cerulli research suggests an illustrative but limited example of this practice: “An example, albeit an oversimplification, would be social issues being more impactful for the financial services industry, while environmental factors may have a bigger impact on the energy industry. In addition to their own analysis, asset managers are leaning on third-party organizations to help their processes. Notably, this includes the sustainable accounting standard board (SASB), which creates standards for nearly 80 industries across 11 sectors for the U.S. economy.”

According to Cerulli, on an aggregate level, company-level data is the real bedrock for determining the materiality of ESG factors across industries. Thus, robust data is and will remain a key to driving investment performance for ESG strategies.

“The data remains invaluable during the security selection process, while analysts synthesize and review the individual companies,” the report concludes. “Availability of data has grown due to increased awareness by shareholders, including advocacy by investment companies.”

Another word on data

As the Cerulli report shows, there is evidence that more investment management companies are using ESG in their due diligence processes, even if this is not a core element of their marketing or product presentation. For example, one anecdote detailed in the Cerulli report tells of a fund manager that is actively filing petitions to corporations for more detailed reporting on methane emissions/reduction targets.

“Cerulli feels asset managers should continue to engage companies they invest in, with benefits being twofold,” the report says. “First, it is in shareholder interest to do so. On top of that, increasing the availability of data allows for a more accurate assessment of the risks posed by material factors. In addition to their own data sources, many firms report using many third-party data providers. … Cerulli contends that asset managers using third-party providers’ data should do so as a supplementary measure, as a means to round out their own proprietary data and analysis.”

As these data accumulation efforts continue, challenges will remain. As the Cerulli report points out, the vast majority of asset managers (94%) still feel that limited/selective disclosure of ESG issues from companies is a challenge to incorporating ESG factors into their investment processes. Currently, by security type, data is most available for publicly traded stocks. Availability tends to increase as cap size increases, Cerulli concludes, while also being more correlated with developed markets.

“Asset manager product plans tend to align with this, as the most common product initiatives for managers are U.S. equity (75%) and international/global equity (72%),” the report concludes. “The final step for asset managers integrating ESG factors is to clamp down on the potential issue of intentionality. A firm can do all the right things by ironing out what factors are considered material on an industry or sector basis, and aggregating the necessary data, but if they don’t intentionally use it, then the integration is undermined.”

Additional findings can be found in the June 2018 issue of The Cerulli Edge – U.S. Monthly Product Trends Edition. More information on obtaining Cerulli Associates reports is here.