As investors navigate this storm, ESG is becoming a leading quality factor.
At a time when extreme volatility and lack of visibility grip the markets, the value of understanding an investment’s underlying quality has become increasingly apparent. Quality companies are usually associated with strong management, financial strength and are strategically well positioned for the long term. Environmental, social and governance (ESG) characteristics are quickly becoming a leading quality factor. As we navigate one of the stormiest markets in decades, we believe corporate ESG leaders can provide some shelter and that an active ownership approach to responsible investing is the best guide.
Passively investing in an index has become gospel. Low-cost access to the longest bull market in history where a rising tide lifted all boats has served many well. So well that many investors have transitioned from researching individual securities to buying leveraged ETFs without considering the value or quality of the companies in the fund. But in a bear market, some popular indexed products are feeling the brunt of the coronavirus pain, while many active managers applying discretion in security selection and risk management have provided a better remedy in the first quarter of 2020.
An ESG index that relies on a single rating provider for construction of its underlying portfolio may suffer from similar limitations. Leading third-party ESG ratings have added tremendous value in synthesizing a company’s ESG profile, but they were designed as a tool to aggregate corporate disclosures and not for alpha generation. As a result, some ESG ratings can be backward-looking if updated infrequently, and there are often discrepancies among the various ESG data providers, underscored by the low correlation between ratings of the same company. Furthermore, multiple less-efficient segments of the market—such as small caps, high yield, emerging markets, securitized assets and private markets—retain less ESG data coverage, making them fertile ground for active owners to identify mispriced risk.
Active engagement helps fill the void
The definition of a passive investor is one who holds all securities of an index without discretion of identifying the winners or losers. At points of market stress, they are forced buyers and sellers of index constituents regardless of how expensive or risky the holdings may be. But assessing ESG risk is not a static one-sized-fits-all approach, so how does one identify sustainable momentum to invest in future leaders? We believe the most effective way to keep your finger on the ESG pulse of a company is through proactive corporate engagement directly with the source.
At Federated Hermes, we are equipped with one of the world’s leading engagement and stewardship divisions. EOS at Federated Hermes International pioneered active engagement and has a more than 15-year track record of engaging directly with company boards and executives. EOS’s mission is to engage in a collaborative dialogue with corporate issuers to better understand material ESG risks and advocate for positive change. These dedicated engagers are ESG subject-matter experts who complement the fundamental research of Federated Hermes investment teams across all asset classes. Integrating engagers’ deep understanding of financially relevant ESG factors supports our global portfolio managers in assessing the underlying quality of the companies in which they invest.
Quality ownership matters
Seeking greener pastures has never been more apparent in a time when macro economists are turning into epidemiologists. By incorporating forward-looking ESG insights into our active investment process, we think we can better assess where the puck is headed relative to passive indexes, which are mostly judging quality through a rearview mirror. Eoin Murray, head of investment at International at Federated Hermes, aptly describes proactive engagement as “a source of idiosyncratic alpha that cannot be systematically replicated by passive managers.” In a fast-evolving market environment, combining deep fundamental analysis with ESG engagement can create an investment edge to help avoid uncompensated risk and skillfully navigate choppy waters when the tide goes out.