Asset Managers: Financial Factors Are Important Part of ESG Investment Selection

Investments should rank well on both financial and ESG metrics, and plan sponsors should know how their asset managers approach ESG investments.

Although there are some retirement plan sponsors that have in-house staff members who manage plan investments, most delegate the selection of investments to an asset manager that is given a guideline, says Sean Kurian, head of institutional solutions at Conning.

However, plan sponsors should consider how an asset manager approaches environmental, social and governance (ESG) investing when they’re selecting one. “In an arrangement where the investment manager evaluates assets, now it’s sort of best practice to consider ESG investments,” Kurian says.

It is important to consider financial metrics in addition to ESG metrics when evaluating an investment, says Mike Hunstad, Ph.D., head of quantitative strategies for Northern Trust Asset Management (NTAM). “When we think about ESG, we think it is the future of investing, but when we put on our fiduciary hat, we have to be concerned that some companies that are highly ranked from an ESG perspective have relatively poor financials,” he says. “We want to be cognizant of both. Companies strong in ESG but also strong from a financial objective tend to get lower risk profile and better risk performance.”

It is very difficult to measure financial factors or ESG factors in isolation, Kurian says. “The financial factors will also include regard about how ESG plays a part in the portfolio,” he says. “Some may be silent on that, but most would usually include that information, especially if there’s a framework for it.”

For defined benefit (DB) plan investment committees, fiduciary responsibility is paramount, Kurian says. “The fiduciary responsibility is ultimately to make sure the plan can meet its benefit payment obligations,” he says. “If fiduciaries are only considering ESG factors in investment selection and the investment performs poorly, it will hinder their overall duty to the DB plan.”

“We do believe integrating financial metrics with ESG factors helps us do our fiduciary duty better,” says Matthew Daly, managing director and head of corporate credit research at Conning. “It’s difficult to elevate one metric over another; if an investment scores very well on ESG metrics but the business is not sustainable, it’s problematic.”

Financial Factors to Consider

Some companies have no profitability, low cash flow or bad balance sheets, Hunstad says. For example, he says, some solar companies have been very highly rated on ESG factors but have very little profitability. He says there’s often a perception that those companies with high ESG orientation also have high financial metrics, but that is not necessarily the case. That’s why it is so important to bring both metrics into the evaluation.

“Asset managers want to consider the quality factor. When combined with strong ESG metrics, investments tend to perform much better,” Hunstad says. “That is why we introduced the ‘Quality ESG World’ strategy. We didn’t design it based on the DOL [Department of Labor] rule, but we are cognizant of what the DOL is trying to say.”

The DOL regulation says plan fiduciaries should only consider “pecuniary” factors when assessing investments of any type—which is to say that they should only use factors that have a material, demonstrable impact on performance.

“When thinking about ESG investing, we want to make sure clients are in it for the long haul and not surprised by an unintended outcome of the investment all of sudden not performing with its intended benchmark,” Hunstad continues. “We can help ensure this through quality metrics. We want to make ESG more ‘sustainable.’”

He explains that profitability is measured by metrics such as return on assets, profit margins and more classic asset turnover metrics. When looking at cash flow, asset managers want to make sure companies have enough liquidity to meet short- and long-term obligations.

“It is widely accepted in the industry that when cash flows become challenged, it’s an early warning of problems with both the balance sheet and profitability,” Hunstad says. “We look at accruals. If a company sells something but that doesn’t turn into cash, it’s a receivable, and they have less cash. It’s a signal of bad cash management. Structuring the cash flow cycle to always have liquidity on hand is a good sign.”

Hunstad says NTAM looks at balance sheets to see whether management is using capital resources in an effective manner. “Broadly speaking, we look at how much debt and equity a company has and how much growth there is in those categories. There are concerns about companies growing too rapidly compared to their peers,” he says. “Issuing too much debt or equity is a red flag. We like stability in the balance sheet to make sure from a long-term perspective that a company can remain solvent and not be challenged financially at some point in the future.”

“When we approach ESG, our framework is one of integration, so we’re integrating ESG risk factors directly into the financial analysis,” Daly says. “ESG factors are included in material nonfinancial information. We consider more holistic information to assess companies, including a company’s creditworthiness and financial sustainability.”

He says Conning would also consider common metrics such as the leverage of the issuer and the forecast for leverage improving or declining, cash flow and revenue outlook. He adds that ESG considerations can provide additional information, for example, by thinking about the evolving regulatory environment and whether that would create additional costs that could affect margins and cash flows.

“One of the big areas we consider is transition risk. How is the company positioned for a lower carbon-emissions environment from a regulatory and technological innovation standpoint? Those things can impact financials,” Daly explains.

“We look at how a company is positioned competitively in relation to its peer universe,” he adds.

It’s also important to consider a company’s trajectory, Daly says. A company may score poorly right now on ESG metrics but have a positive long-term outlook. He says that is a good place to allocate capital.

“The concern is that companies with high ESG ratings are challenged financially; plan fiduciaries want to make sure they are using investment options that are good on both metrics,” Hunstad says. “If the company has no profitability or declining profitability over time, that is not a good representation of doing your fiduciary duty.”

Kurian reiterates that it is hard to separate financial factors from ESG factors. “The way it was done a few years ago was to create silos—here is my ESG box and here is rest. But the landscape has changed and studies have shown how ESG is highly correlated to certain companies outperforming,” he says.

Values-Based Investing Is Different

Previously, plan sponsors might have practiced what was called “socially responsible investing (SRI),” divesting from companies that were either found to be doing business with bad characters or that were perceived to be in the production of harmful products, e.g., firearms or tobacco.

Kurian says SRI relates to the culture of the company, but he notes it’s tricky, especially if those investments that are excluded are doing well. “Plan sponsors have to answer whether their portfolios represent the value of their organizations,” he says.

“What we’ve been talking about is the integration of ESG factors in the overall assessment of investments, but values-based investing is different,” Daly says. “Whether one wants to dedicate capital or not to, for example, tobacco companies is very specific to the plan sponsor.”