Environmental, social and governance (ESG) investors must become aware of the risk of ‘impact washing’ as more fund firms target the UN Sustainable Development Goals (SDGs) in their investment approach.
The challenge has led US impact investor American Century Investments to construct its own metrics for assessing impact especially in emerging markets.
Guillaume Mascotto, head of ESG and investment stewardship, says there is a $3.3trn (€3.0trn) gap in terms of the private money that needs to be invested in public markets to address the SDG goals in emerging markets.
He says: “There is this gap and there is this huge opportunity. But how do we go about measuring the impact? Managers need to have a rigorous process that maps directly into their fundamental research.”
He says the asset manager doesn’t want to be seeking to align a mandate with the SDGs after the fact. Indeed, within its processes, an analyst cannot pitch a stock to a portfolio manager unless there is a direct alignment to an SDG, otherwise they will not invest.
However, it does require real world testing and finding a metric that may not be commonly accepted.
He gives the example of a company that might be establishing an education network in China, which ostensibly meets SDG four on education.
“If it is education, we need to see a metric to tell the investor it does provide impact. We mandate both the ESG team and fundamental analyst to find those metrics. Those metrics may not be commonly accepted. They are not really available. You can’t expect the EM companies to be as transparent as US, UK or Canadian large caps.”
He says that may also mean considering whether the region is impoverished, asking for figures on who graduates and even who ends up having a job.
“Then we can explain to investors how it also has alignment with the goals around improving economic conditions and alleviating poverty. So it speaks specifically to a positive goal.”
He says that the firm wants to avoid ‘impact washing’. He says you might have a company in the healthcare space that appears to meet one of the goals, but that has bad governance or is involved in controversy elsewhere.
He also suggests that other firms are simply excluded.
Thus, the firm avoids companies that violate the UN global compact, the International Finance Corporation Exclusion list and many business lines – tobacco, coal, dirty oil, controversial weapons and alcohol are screened out.
“With all of these product lines, even if companies do good for their employees and suppliers, we don’t understand how they could be aligned with the SDG goals,” he adds.
ESG ratings divergence can lead to mispricing
He says that investors can more generally take advantage of mispricing from ESG rating companies.
He adds: “It is important to understand that the correlation between the various third-party rating indices is quite low. With the most recent research, benchmarking all the third-party ESG ratings, the correlation was about 0.6. If you compare this with credit ratings, the correlation is about 0.99.
“It is important to understand that managers have the capability to have their own view in order to find the ESG disconnect.
“With our proprietary score, we might have a stock rating, single B or triple C, and have a strong conviction it was not capturing the true ESG fundamentals. After a couple of months, the third parties had updated the stock, ESG was able to find that disconnect, to find the mispricing.”