As sustainability increasingly becomes part of the conversation within corporate treasury departments, Karyn Corridan CFA®, Lead Portfolio Manager for State Street ESG Liquid Reserves Fund, State Street Global Advisors, evaluates the impact of ESG criteria on short-term cash investments.

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.

New drivers

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.

Data challenge

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.

Building on our transparent R-Factor scoring system, we are proud to offer one of the asset management industry’s most comprehensive and innovative solutions for ESG-focused cash management.

Additionally, prime money market funds may also hold asset-backed commercial paper (ABCP) and repurchase agreements secured by non-government collateral (referred to as alternative repo). However, evaluation of the ESG performance of the repo bank counterparty or ABCP liquidity provider does not reveal the full factors at work for satisfactory inclusion in a client’s ESG mandate. The underlying collateral needs analysis. But for any asset manager, performing satisfactory reviews of this collateral is often subject to limited internal resources and expertise and, most challengingly, a lack of reliable and transparent ESG data.

There are challenges, but that doesn’t mean investors need to ignore sustainability factors in their cash management strategies. We are committed to solving these challenges, and we have dedicated a significant amount of research and resources to creating a cash management solution built on a unique and dynamic ESG scoring, screening and tilting process.

Meet R-Factor™

In response to the data challenge, State Street Global Advisors has developed a transparent ESG scoring system called R-Factor (where ‘R’ is Responsibility). Leveraging multiple data sources (including Sustainalytics, ISS-ESG, Vigeo-EIRIS, and ISSGovernance), and SASB’s financial materiality framework, R-Factor generates a unique score for individual companies.

R-Factor was built to solve the data quality problem, and to remove opaqueness around ESG materiality in the scoring process. It measures the performance of a company’s business operations and governance as it relates to financially material ESG issues facing the company’s industry. Importantly, each score is dynamically adjusted as each element changes.

We are seeing more investors appreciate that ESG considerations influence the sustainability of returns in all asset classes. For investors, R-Factor offers a standardised, bias-free and comparable view of the ESG components that focus on the financially material ESG issues shown to impact companies’ long-term performance. In doing so, it is opening up our clients’ corporate cash management strategies to the full and transparent incorporation of ESG factors.

By excluding a small subset of instruments and issuers involved in controversial practices or those that lack necessary transparency, ELR provides 100% coverage of our stated ESG criteria. By applying a sophisticated tilting process that assesses the R-Factor scores of the issuing counterparty — and, for ABCP and certain types of alternative repo, giving consideration to the underlying collateral — we can provide our clients with a scalable ESG cash management strategy that achieves investors’ objectives.

As ESG-centric money market products continue to be introduced in the marketplace, we believe that State Street Global Advisors is uniquely positioned to solve these challenges. Building on our transparent R-Factor scoring system, we are proud to offer one of the asset management industry’s most comprehensive and innovative solutions for ESG-focused cash management.