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As we continue to see growing inflows for ESG investors, it might have been a surprise to many that during the COVID-19 pandemic ESG ratings did not appear to provide the risk mitigation benefits investors had hoped for. We explore the possible reasons behind this and how, despite the ESG ratings, active analysis of intangible assets can provide additional benefits to investors. [7 minutes, 28 seconds] (Recorded August 12, 2021)


Hello. This is Jeremy Richardson from RBC Global Asset Management, and I’m joined today by Ben Yeoh to discuss the performance of ESG over the course of 2020. A big year, obviously. We had the pandemic; a lot of moving parts. So with the benefit of hindsight now, I just want to invite Ben to perhaps look back and share some reflections on how ESG overall performed. Ben?

I think there’s been a perception that companies with strong, say, ESG assets did very well across 2020. However, I do think if you dig down, you might find a lot of what we call an ESG factor was intersectional with a lot of other forms of intangibles, so how companies looked after their human capital; how they responded to pandemic; as opposed to what you might have considered some maybe more tick-box elements of ESG in terms of your governance policy or your diverse policy on the like. So I think the perception is that they did quite well. But I think the reality is a little bit more of a complicated picture. And I don’t know if you picked up, there were a lot of kind of practitioner studies looking at this, but I have a little bit of skepticism over maybe some of their conclusions, partly because of the nature of the datasets and partly because I wasn’t exactly sure what they were pointing at or doing.

Yeah. I think I would entirely agree with you. I think there is a sense that ESG had a good pandemic—if I can say that—that it demonstrated why it was relevant. And I think that’s being supported by the flows that we’ve seen in terms of capital into ESG-led strategies. But what I thought was really interesting is the observation that when you look at a number of their sort of ESG indices, it’s really, really hard to see any of that outperformance. It does make me wonder a little bit that when it comes to ESG, that investors are sort of looking at it like some sort of magician’s trick and we’re sort of believing in something that we want to be true. But when you look at the backward-looking data, in terms of the way that ESG indices have performed, they’re almost exactly in line with sort of non-ESG, or sort of more broader-based cousins. And I think it really does sort of challenge this notion that ESG was the right investment strategy over the course of 2020. Now, I know that we’ve spoken about this before, Ben, there’s a lot of limitations around ESG indices, of course. I mean, they’re typically pulled together in term—using ESG scores, and that can be problematic at times, can’t it?

Yeah. I think it highlights two problems to me. So one is your actual data source; and the second is actually in the construction of some of these benchmarks. Because if you look at their benchmark construction, some of them are not that different from the so-called standard benchmarks. So in some ways, you wouldn’t have expected them to perform that much differently because they’re very worried about what investors call sort of tracking error, actually tracking these things relatively smoothly. So on the one hand, some of these people could say, well, that’s kind of what they were designed to do. On the second point though, you are also exactly right, that there are very many ESG data sources and data rankings. And these rankings are still judgments done by rating agencies which, in some areas, have limited agreements, change over time, so again, backward looking, but also not necessarily what you would do. And a third problem is that when you’re looking at such a plethora, such a number of ESG data sources, you kind of get this tyranny of the average. When you average out 100-over or 50-over data points, some of it which might not be as material or some others, you might dilute whatever signals you were hoping to find because, I think most people would agree, out of 50 data points, a lot of those wouldn’t necessarily be relevant. So there are kind of quite a lot of issues cropping up within that benchmark system, which I’m not certain that everyone is fully up to speed with.

But then, Ben, if you are looking over a large number of companies, if there was such a thing as an ESG factor, almost by definition, that’s how it should present itself, right? It’s a shared characteristic. And so if your index is created in a way to exploit that, then in theory at least, it should be observable in the numbers. And the fact that it generally hasn’t been, perhaps for some of those other reasons you also explained, I think it does sort of challenge this notion that 2020 was a time when ESG was really going to pay off. And yet, I can’t help but think about some recent papers that have been published which, actually, are trying to approach this from another angle, which is instead of looking at ESG scores to try and explain share price performance over the course of the pandemic and also the rest of 2020, they are suggesting some other ways of thinking about important drivers, which are taking into account sort of extra financial sources of information if I might put it that way. So things like sort of definitions of intangibles, which I know—it seems quite strange, doesn’t it, to have a definition of something which is intangible—but we can perhaps get a proxy of that in terms of spending and things, or things like research and development and SG&A spent. And away from procedures like natural language processing to get a sense of the stakeholder relations that a company enjoys. Have these types of analysis actually indicate that these sort of more broad and more holistic sources of sort of contingent assets, as we would call them, are actually have got some explanatory powers in being able to determine the path of share prices over a period such as we’ve seen over the course of the—over the pandemic.

Yes. I would agree. And I would raise two points. One is a lot of what we call intangible, or extra financial ESG, is often what we might say idiosyncratic or specific to a company. Corporate culture, for instance, by its very nature, you want a good one and you want to avoid a bad one, but tend to be specific to actual companies as opposed to something like company size which you might have some quantitative factor associated with it. The second is I think this is in line with other work that we’re seeing where you look more narrowly at actually specific factors. And so, for instance, I think of the work of Professor Alex Edmans looking at a human capital factor through employee engagement. And there, you do see consistent returns. You’ve got a strong theory for why that might be and something that you could track, and that is an intangible that we know in theory should add value and seems to be the case as opposed to these kind of, as we said, the problematic kind of ESG scores actually honing in on a material data point. So I do think looking at these extra financial data sources, maybe some of which aren’t accounted for as well, are indeed, productivity, human capital, positive corporate culture, some of this which you might have to get in a way of stock-specific judgment rather than having to rely on a kind of a computer [forecast].

Yeah. So maybe thinking about using ESG as a tool, as an input into a process in order to be able to get close to those sort of intangible assets, those contingent assets that are often idiosyncratic that can really sort of make a difference over I suppose a long-term share price performance. Ben, look, thank you very much for you insights. Always a pleasure and look forward to catching up with all of you again soon.


Recorded: August 12, 2021

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