A Two-Step Approach to ESG Investment Analysis

The first step involves choosing an optimal mix of asset classes based on traditional measures of risk and return, and the second involves tilting the portfolio toward ESG leaders or “improvers” within each asset class.

J.P. Morgan Asset Management has published an update of its long-term capital markets assumptions in the form of an extensive new report that, in addition to making baseline economic assumptions about the next five to 10 years, presents various thematic articles on specific, current trends.

Among these is a close look at environmental, social and governance (ESG) investing, particularly how institutional investors in the United Sates are warming to ESG approaches and their potential role in investment processes and decisions.

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As the report explains, interest in sustainable investing is growing globally among a wide range of market participants. While some investors have long been motivated by environmental or societal objectives, others are seeking new financial opportunities in the companies that stand to benefit from rapid changes in consumer preferences, policy and regulation, spurring further interest in sustainable investing. All this to say: Grappling with ESG investing in today’s marketplace is a potentially challenging affair that brings with it substantial opportunities.

According to J.P Morgan’s analysis, in general, investors tend to consider ESG factors either to increase risk-adjusted returns (which the report calls “doing well”) or to achieve sustainable outcomes (i.e., “doing good”). In their analysis of this bifurcated framework, J.P. Morgan’s analysts find no meaningful trade-off between doing good and doing well when investing in public markets.

“A sector-neutral equity portfolio is not hindered, relative to its benchmark, by a skew toward ESG leaders, defined as companies that perform well on J.P. Morgan Asset Management’s ESG scoring framework,” the report explains. “In fixed income, while there is evidence that higher-ranked ESG issuers pay lower coupons, investors are likely to be compensated with lower default risk.”

J.P. Morgan’s analysts say there are two channels through which sustainable business practices can help companies outperform their peers and generate higher returns for investors. The first channel is market forces, the report explains, where the costs of nonsustainable practices play out and can hurt a company, either because it suffers the effects of regulation or because it fails to meet consumer preferences. The report suggests this “market forces effect” will be persistent through time.

The second channel is via increased demand—and thus higher prices—for these companies’ shares relative to their lower-scoring peers. The report calls this a “repricing” effect, suggesting it may likely be transient as market participants price in ESG considerations more accurately.

At a high level, the report states, total return results will vary depending on which of the many ESG rating systems are being used. As such, across both equities and fixed income, choosing an ESG rating system that produces reliable ESG “scores” is a critical choice in sustainable investing.

“Investors who want their portfolios to have a minimum ESG score might be tempted to avoid certain markets or regions, such as the emerging markets,” the report notes. “However, our analysis shows that because of the wide variation of scores in every region, a better portfolio solution is one that optimizes first on region and then within a region on ESG score.”

Similarly, according to J.P. Morgan, investors should not be discouraged from investing in private markets just because ESG data can sometimes be harder to obtain.

“Indeed, turning away from private markets can be a real loss because these markets are increasingly providing portfolios with solutions for attaining income, diversification and alpha,” the report concludes. “ESG information can be less transparent in private markets, requiring more research and investigation. But investment in private markets not only can help achieve return objectives, it is also likely to be essential for achieving sustainable outcomes as private markets grow in size and importance.”

The analysis suggests investors may again wish to adopt a two-step approach: The first step is choosing an optimal mix of asset classes based on traditional measures of risk and return, and the second is tilting the portfolio toward ESG leaders or “improvers” within each asset class. The report says the second step is likely to be more difficult in private markets.

The report further concludes that incorporating ESG considerations does not come at a financial cost—unless investors reduce their opportunity set to assets whose ESG characteristics are easy to score and for which scores are readily available.

“As we’ve discussed, investors will want to consider different approaches for different asset classes, for example, by focusing on material ESG risk when assessing bonds, while considering both risks and opportunities in the context of equities, while taking into account the important role played by rating agencies and scoring systems,” the report says. “Given that ESG investing does not come at a cost in terms of performance, it can be seen as a ‘free option’ to align portfolios with investors’ values, as well as to prepare portfolios for the impacts of potentially tighter environmental or social regulation.”