Getting the language right: the Hermes ESG lexicon
Even though ESG investing has become standard practice among asset managers, a standard set of ESG definitions has not yet been established industry-wide.
For this reason, we have decided to wade through the noise and present our view on ESG investing.
At Hermes, we believe there are two mutually reinforcing strands of responsible investment management: responsible investment and responsible ownership. Together, these aim to generate sustainable wealth creation for the end beneficiary investor encompassing both investment returns and their social and environmental impact.
Prevalent responsible investment approaches can be categorised into four different – but not mutually exclusive – activities:
- Negative exclusion: applying exclusions – or negative screening – to the investment universe at sector or thematic level, typically based on moral, ethical or religious beliefs. For example, avoiding investments in the tobacco industry or those based on climate change;
- Positive screening: actively investing more in – or overweighting – companies and assets that demonstrate relatively better environmental, social and governance credentials;
- Impact investing: investing in (or engaging with) companies which have (or could have) a central purpose of solving societal problems, such as those set out by the UN SDGs; and
- Mainstream ESG integration: integrating material ESG and other sustainability factors as well as insights from engagement, alongside fundamental business-performance factors, in mainstream investment decisions.
Another integral element to responsible investment management is responsible ownership – that is, being a good steward and owner of companies and assets through asset engagement and advocacy:
- Asset engagement: actively engaging with companies to align their behaviours with the long-term interest of clients and their beneficiaries by improving the strategic, financial and ESG performance of companies and assets; and
- Advocacy: engaging with public policy makers, regulators, governments and industry bodies on enhancing governance, environmental, social and stewardship standards globally as well as regionally, at a thematic-level (such as climate change or diversity) or by industry sector.
Figure 3. The Hermes responsible investing and ownership roadmap
Source: Hermes as at January 2019.
Armed with a better understanding, investors should be able to identify the four distinct approaches to ESG investing.
Importantly, our definitions highlight that our Global Equities team adopt a mainstream ESG integration approach. Indeed, we have followed this approach since the team’s inception in 2007 – long before ESG investing had entered the mainstream.
By combining quantitative tools with a qualitative assessment and active ownership of positions through our responsible investment and engagement specialists, Hermes EOS, we aim to achieve capital appreciation by investing in global equity securities with favourable ESG credentials. We use four main tools:
- The Alpha Model is our “automated analyst” which assesses the attractiveness of every investable company in our universe on a daily basis. The metrics used to select stocks are justified by both economic reasoning and statistical effectiveness, and have a long-term focus that leads to low portfolio turnover. They are grouped into six categories: valuation, corporate behaviour (including governance), growth, profitability, capital structure and sentiment. The model identifies which stocks have the most attractive combinations of these characteristics and the output is subsequently used to create an optimised portfolio that aims to maximise risk-adjusted returns. The Alpha Model also uses proprietary data from Hermes EOS to incorporate an assessment of corporate governance in every valuation (see The Alpha Model: laying the path to consistent returns).
- MultiFRAME is our proprietary risk model which assess top-down market risk. It has the flexibility to stress-test the portfolio, interpret how it would respond to different market environments and measure its exposure to any quantifiable risk.
- The ESG Dashboard forms an important part of our qualitative analysis, enabling analysts and portfolio managers to easily incorporate ESG analysis into their stock-picking processes and, importantly, to flag stock-specific sustainability risks. The Dashboard provides a concise digest of the ever-increasing amount of data on ESG risks. As well as incorporating a wide range of research from leading data providers, the report includes proprietary information from Hermes EOS on voting and engagement. Indeed, Hermes EOS has helped define the key performance indicators or risk factors on which each company is measured. These are either generic, such as board structure, or sector specific, focusing on the major risks by industry – such as CO2 emissions and fleet consumption for the automobiles industry, paper sourcing for media and energy efficiency for airlines (See ESG Dashboard 3.0).
- The ESG Portfolio Monitor shows aggregate ESG risks within a portfolio, in absolute and relative terms. By knowing the source and magnitude of these risks, portfolio managers can better manage them. It contains data from Hermes EOS, as well as leading data providers and our proprietary QESG Scores.
These tools allow us to follow a mainstream ESG integration approach – that is, incorporating ESG considerations alongside insights from engagement, valuation, growth prospects and market sentiment, among others. Our model favours companies with an attractive blend of these characteristics.
Our case studies below – Bank of America and Thermo Fisher – demonstrate the practical application of a mainstream ESG investing approach, where we have seen the significant impact that the consideration of ESG characteristics can have on our valuations.