Finding order – and alpha – in the ESG chaos

Many fund managers are wary of ESG because they are unaccustomed to investing based on something other than financial returns. But for those who do it right, could ESG be an alternative data goldmine, writes Apex Group's Jason Meklinsky.

Everywhere you look, investors and regulators are rushing to adapt to environmental, social and governance (ESG) demands in the markets. The European Union has enacted the SFDR, new rules around ESG disclosures. American regulators recently announced that non-financial data will remain an “examination priority” this year.

It can feel like a headache, especially for global funds and financial services firms that have to adapt their compliance and data operations to these different regulatory regimes. It’s hard to blame buy-side fund managers for yearning for a simpler time. But ESG reporting isn’t just another task that distracts from the core business of money making. For alternatives funds seeking to make order out of the chaos, ESG reporting can be a source of alternative data — and an opportunity for alpha.

The buy-side need to know where to look, however. As investors and advisers push for greater transparency, they need to be prepared to turn ESG-related information into data they can act upon. That requires the skills and specialists who can draw on mountains of ESG data to find insights that drive returns.

US adoption lagging

There’s a continental divide in ESG at the moment. A 2020 survey from the Royal Bank of Canada found that European investors were more likely to use ESG factors in their investment decisions compared with their US counterparts (94 percent compared with 65 percent) and are more confident that ESG-integrated investments would outperform traditional investments (68 percent vs 28 percent.) A majority in both regions see the value of ESG factors in mitigating risk, though.

If investing were a soccer match, many US funds continue to see ESG reporting as the domain of their compliance offices who are like goalkeepers who stop goals rather than a tool for their sales teams to score and generate revenue. European soccer is largely considered to have the best teams, and their investors, who are ahead of the curve on ESG investing, tend to believe that both perspectives have merit.

That’s not to say that ESG factors are not growing more prominent in the US. Quite the opposite, in fact. Retail and institutional investors alike are pouring money into sustainable funds on both sides of the Atlantic. In the US, sustainable funds attracted $51.1 billion in capital in 2020, doubling flows from 2019 and marking a ten-fold increase from $5.4 billion in 2018, according to Morningstar. Researchers at Harvard Law School recently predicted that 200 new funds with ESG mandates will launch in the US between last year and 2023.

ESG-minded investors want to know that their money is moving the needle in fighting climate change, raising living conditions around the world or fixing corporate cultures — or at the very least not making those things worse. Regulators are trying to make sure that the data reported on these factors is legitimate, preventing “green washing” and its equivalents in the social and governance realms.

But the differentiator in ESG investing will not just be which funds can competently report on how they measure up to these factors – but which funds can scout and discover ESG-related insights elsewhere that inform their investment strategies and bolster financial returns and performance.

An alternative view of ESG

Trading and asset management firms were expected to spend $7 billion on alternative data last year, according to Deloitte. The methods for gathering this data might range from scraping social media sentiments to scouring the web for local weather reports and agriculture forecasts.

But if someone is selling alternative data, other people probably already have it, too. That’s hardly a recipe for differentiation. It’s counterintuitive, but sometimes cheap and less sought-after data can be just as informative or even better. As alternative data provider Quandl co-founder Abraham Thomas told Forbes, “Maybe 99 percent of [alternative data] is junk, but 99 percent of everything is junk. But that one percent can have big value.”

In other words, it’s not about finding secret or ironclad data, but finding correlations in available data that no one else is seeing, like the classic example of investors who found in 2012 that some Twitter metrics could help predict fluctuations in the S&P 500.

So where might you find alternative data insights arising from ESG concerns?

  • As the costs of employment lawsuits becomes a significant financial concerns for companies, ESG reporting offers comparative insights into how seriously companies are about advancing gender parity and diversity, equity and inclusion initiatives that might impact their public images and growth in the years ahead.
  • Environmental efforts often have a material impact on the bottom line, of course, as McKinsey has highlighted. 3M saved $2.2 billion through its pollution prevention efforts over four decades. A water utility saved $180 million per year by pursuing lean initiatives. FedEx has reduced fuel consumption by more than 50 million gallons by converting its fleet to electric or hybrid engines.

These approaches will change. The Royal Bank of Canada survey found that only 41 percent of European investors and 38 percent of American investors are satisfied with existing reporting. Expect to see companies do better, both because of the market opportunity and because regulations will force their hand.

Even as many US buy-side investors still see these changes and additional disclosures as a nuisance, the paradigm is shifting. Sustainable investing, created as a way for money to make the world better, is also an opportunity for alpha. Those who embrace the new reality will accelerate ESG investing’s positive impact on both fronts.

Jason Meklinsky is Head of Americas Business Development, Hedge Funds, Private Equity, Real Estate and VC at the Apex Group.