More than 1000 asset owners and service providers have signed up to the United Nations Principles for Responsible Investment, and yet the question on everyone’s lips remains how to actually integrate sustainability into the investment process and ultimately add alpha. Bill Mills, managing partner of Highland Good Steward Management, has an idea and a platform for such a solution.
As with any integration process, empowerment is crucial; for integrating environmental, social and corporate governance (ESG) into investment processes it is no different.
Mills is working on the premise that ESG information can be turned into alpha and it rests with empowering the investment decision-makers.
His solution is a labyrinth of players which are involved in a continuous multi-directional loop of information. But the secret, he says, is to leave the responsibility for decision making, with the fund manager.
The Highland Good Steward Global Bond Fund, which uses Pimco as the sub-advisor, has an emphasis on changing the behaviour of borrowers in a long-term sustainable way, but also to remain flexible enough to maximise short-term opportunities.
The key, Mills says, is to provide ESG signalling to the underlying manager in order to guide its long-term decision-making in sustainable companies without limiting its shorter term investment discretion.
The philosophy is that the outcome will be achieved by collaborating with the manager rather than replacing the manager’s judgement.
“Philosophically, we do want a sub-advisory based on traditional asset management with a track record. But we want to stimulate their thinking, not change their thinking, for ESG, but ask them to think deeper,” Mills says.
“What underpins all of this is that you don’t tell managers what to do. You hire the best managers, listen to them and work with them.”
There are a number of differences in this approach that distinguish it from simply overlaying a process with ESG information on a company.
How data signalling and engagement work
Highland Good Steward Management (HSGM) has developed a consortium of research firms that provide company ESG and socially responsible investment (SRI) information. This is fed to the manager as additional information for securities selection, of which the manager retains ownership.
The research consortium includes ECPI, Eco-Frontier, MSCI, CAER, EIRIS, and SocioVestix Labs, and produces a grading on 7000 companies for the individual elements of environment, social and governance, as well as a consolidated ESG rating.
“The data from these providers acts as a signal for the portfolio managers to use, alongside financial and other data used for analysis.”
“Highland will not limit Pimco’s investment choices by negative screening. Instead the aim is to collaborate with the manager in their search for additional alpha by integrating ESG considerations into their investment analysis.”
But it doesn’t stop there. Another element of the process is the use of a service, provided by Hermes EOS, to engage with corporations before and after the investment decision.
Colin Melvin, managing director of Hermes EOS, says engagement is a way of looking at longer term decisions and aligning the client.
“We have an engagement indicator that measures the quality of the company and its responsiveness to engagement. If you are considering it as part of the normal decision-making, then you want fund managers to do it as they do other things. But you can also use it to challenge managers on their decisions,” he says.
“For many, these issues have been taboo for funds managers. They have been overly impressed for too long by short-term decisions.”
Hermes engages this way with about 500 companies globally.
For this relationship, the engagement starts with investors suggesting themes. These currently include climate change, access to and utilisation of water, operations in troubled regions, supply chain, and access to medicines.
Hermes then suggests to HGSM certain companies that may have potential for engagement breakthroughs. This list is then taken to Pimco for the manager to analyse as possible portfolio holdings on the basis of their investment thesis.
If Pimco invests in these companies, which is at their discretion, then Hermes engages in focused impact engagement in order to accelerate the corporate and potential changes in share value.
It also works the other way: if Pimco invests in companies outside the HGSM research-consortium database, then HGSM can request that a research report on the company be performed by one of the research companies, and Hermes may also engage with that company.
“It is incorporating the manager in the process. We can take all the holdings in the fund and download them into research,” he says. “Over time we can see how the portfolio is moving towards E,S,G or not.”
Case studies on the HGSM platform
Mills points to the example of two companies as to how the process may work. On a corporate level, the companies would be analysed on a theme and how they engage with Hermes, and then ranked.
Say, for example, company A has improved its water management, which will be reflected in a good environmental score, but it has a tight yield spread. Compare this to company B, which historically hasn’t taken Hermes seriously on water engagement and has a low environment grade, but its yield spread is higher.
In recent times when Hermes engages with company B, it now wants its senior management to be involved, which is sending a different signal about how it is approaching the issue. HGSM sends the information to Pimco, instructing that it is a signal to be fed into the analyst’s process.
“They love that,” he says. “Everyone wants to prove ESG works. It entirely depends on the time frames, the same way for example value and growth does. We have been attaching the wagon to the wrong thing and setting ourselves up. The ideal way is corporate engagement – it is the only way to determine a company’s DNA.”
“You can be more explicit in engagement than data providers can be on performance. But the engagement partners are selected not with an eye to embarrassment but effective engagement.”
“We would go back to Hermes and say that water engagement is important to my client and Pimco bought 500 bonds on that basis. We will also share with the company we’re engaging with.”
“This is a long-term monitoring process that makes sense, it’s better than trying to prove alpha exists,” he says.
Mills is now transferring all the data from this platform to Microsoft Cloud, which makes it immediately customisable.
sorry, failed methodology
Frankly, this is just another fix to a fialed methodology.
Of course we are all trying to ultimately add alpha, but we will never succeed if we continue to use failed methods. The market is a price determination mechanism based on perceived current and future value. Alpha is achieved by owning companies that collective have greater value over a period that the general market.
Subjectively ranking of companies against subjectively created environmental, social or governance metrics does not stimulate market price behavior. In fact, the market largely ignores it and has done since we came up with the ESG acronym in the first place. Yet we keep trying different permutations of the same wonky process hoping that it’s the market that’s wrong and not our process.
With all due respect, Mr. Mills suggests that we empower an already empowered underlying manager by providing him with a really good secret; more information; information that is not meant to change his thinking, but to stimulate a deeper thought process. Are you kidding me? Are we managers so thick that we need to outsource to think deeply enough about what we are doing?
And what’s in this new secret sauce. It is more, literally, subjectively selected ranking data, hugging an acronym from a consortium of information providers, with the added benefit of another subjective rating by an engagement agent.
Surely, it makes more sense to bin the failed methods and think a bit more objectively. Find hard data in companies that have verifiably implemented processes which lead to a better utilization of environmental inputs. Those companies tend to have better environmental track records.
Identify companies that themselves set standards, measure and manage their social and environmental responsibilities. Those companies tend to exhibit the characteristics of good corporate governance.
What you may find, to your surprise, is that a portfolio of these kind of companies also produces alpha, and in good measure.
The reason that managers don’t do this is because it is hard. So we outsource subjective ESG information gatherers to appease our consciences and our handlers, think very deeply about the impact of important things, and ultimately disregard them because they doesn’t add price moving value.
The alpha is not in the acronym. The old methods are broke and need fixing, not patching.