As environmental, social and governance (ESG) investing becomes more mainstream, advisors must decide how to get the most out of it.
Abdur Nimeri, senior investment strategist for FlexShares ETFs (which offers a pair of ESG funds), believes that success depends on how clients and advisors choose to define ESG's role in a portfolio.
Most advisors treat ESG investments as satellite positions — not part of the core. Nimeri attributes this phenomenon largely to confusion between ESG and socially responsible investing (SRI). While there is overlap between the two, SRI generally features a more exclusionary view, eliminating companies that don’t meet certain philosophical criteria (such as sin stocks) and selecting those that do. In Nimeri’s eyes, ESG investing is morally-neutral. He seeks to learn more about how a company performs in certain areas relative to its peers, regardless of industry, to help inform risk/reward calculations.
“We see this correlation between ESG and risk,” Nimeri explains. “The ability to ascertain which indicators are significant to the risk reduction asset or return generation is very critical in the process of translating the available data to shareholder value.”
It’s this connection that leads Nimeri to maintain that ESG is best suited not as a satellite, but as the core of a portfolio. That belief that leads him to look at companies that aren’t exactly the first names that spring to mind when you think “socially responsible.”
“The large-cap space tends to be significantly more robust in voluntary disclosures, so the body of data around large caps is fairly substantial. As you move down to mid and small, it can be a bit less robust," Nimeri says. "You tend to skew towards large cap as a result of more aggressive data output, like from long-tenured shareholders who have been banging on Exxon Mobil’s door for decades, as opposed to a company started five years ago that really doesn’t have the same public profile.”
Nimeri’s funds include Exxon Mobil, the paragon of environmentalism. However, that realization is only odd if you concentrate on the “E” in ESG, as most people do. Nimeri is more interested in the balance between the three, which he finds is often driven by the “G.”
“The data suggests that strong governance tends to front run social and environmental policy. The environmental side has the least pull because not all firms have significant environmental or workplace safety issues,” he explains.
Exxon Mobil is a company that does have significant environmental issues, but Nimeri stresses the importance of balance. In Exxon’s case, strong performance in the other two factors can outweigh one questionable area.
According to Nimeri, “Frame of reference is important. You have to look at how they perform within their sector. That’s how you end up with an ESG portfolio that can be a core investment. For instance, Wells Fargo, despite the recent controversy on the governance end, is still a good actor when it comes to ESG within its peer group.”
So, what are some examples of the key performance indicators that Nimeri looks at? Environmental policies, like energy or carbon dioxide reduction targets, can be useful information. Good social indicators include the percent of women on the board or the company's community spend. For instance, he notes that Proctor and Gamble does a tremendous job of community outreach in Cincinnati. On the governance end, he takes into account anything that impacts or impedes shareholder involvement, such as poison pill policies.
However, Nimeri cautions that many of these elements overlap and are akin to double counting (occasionally in opposite directions), so advisors need to determine which element is truly material to risk and performance. For example, the percentage of women on the board is negatively correlated to the number of independent directors. Because there are fewer women in the upper echelons of the business world, the same ones end up serving on multiple boards, so you have to ask yourself, which one matters most? They’re uniquely related and would cancel each other out otherwise.
“Automatically screening out a company because they’re questionable in one area is a thing of the past,” Nimeri maintains. “We’re looking to have allocations across sectors and be sector-neutral relative to market-weighted indexes to not have a large tracking index.”