Systematically including or considering ESG data as part of an investment process is becoming an increasingly critical component to investors’ investment decisions. But approaches to assessing what ESG really means in the context of a portfolio have often been subjective, until now.
We have seen various methods of including ESG considerations in an investment portfolio. Traditional exclusionary screening strategies continue to be used, removing particular companies, sectors or countries that do not align with a particular set of values. We’ve also seen clients adopt a thematic approach, concentrating on a particular area, such as climate.
Another focus has been on ESG ‘best-in-class’ strategies, where investment in sectors or companies are selected for their apparent superior ESG performance, relative to their respective universe or industry peers. Others have adopted an ESG integration approach, where ESG factors are integrated as part of the investment process which has led to an increase in demand for 100% ESG-aware portfolios.
To reflect this goal, in July 2019 we launched the State Street ESG Liquid Reserve (ELR) fund, a prime money market fund investing in instruments that meet our ESG criteria.
Knowing that cash management plays a critical role in our clients’ investment portfolios, we overcame some pressing challenges in implementing material ESG criteria across ELR. But we met those challenges by creating a unique solution to the problem of assessing the ESG components of a portfolio’s underlying assets.
The degree of client engagement in portfolio construction depends on individual ESG drivers. The relevant motivator influences the approach taken. But one thing is certain: whilst an exclusionary approach is still favoured by some investors, others are becoming proactive as they seek to bring cash into their ESG portfolio. These investors understand that it’s about more than just ‘doing the right thing’. They know that it actually matters, and are now insisting on inclusionary screening.
Various barriers have existed for some potential ESG investors. Where, for example, a fiduciary duty is imposed, it has kept some from adopting ESG implementation due to perceived hinderance on returns. But there is now growing recognition that mitigating ESG risk actually aligns with fiduciary duty and may provide better risk-adjusted returns. Our clients are focused on maintaining their primary objectives while incorporating ESG criteria.
In a money market fund, principal preservation and liquidity are paramount while earning a competitive yield. Our clients are looking to achieve these goals while achieving ESG objectives.
Across all asset classes, the lack of reliable and consistent ESG data has kept investors from implementing ESG considerations to their investment process. Numerous third parties provide ESG ratings using proprietary methodologies, with varying degrees of transparency. Assessments of a single company can produce wildly different results, so for the sustainability-focused investor, adopting positive screening methods is a problem.
Additionally, relative to other asset classes, integrating ESG considerations into a publicly traded cash strategy presents unique challenges. Money market funds face regulatory and investor-driven requirements to maintain high levels of liquidity and security. These funds primarily hold sovereign debt and securities issued by high quality large banks and financial institutions which leads to a concentration of 35 or so AA- or A-rated global banks that access the market daily.
In applying an unrefined ESG filter, the exclusionary approach would further limit that investible pool – potentially increasing fund concentration risk.