Morgan Stanley
  • Investment Management
  • Nov 15, 2016

Helping Stock Portfolios Steer Clear of the Rocks: An ESG Risk Analysis

Fines on companies for breaking environmental and governance regulations are now so large that investors need to detect potential ESG risks to equity investments and sustainable investing funds before they happen.

It’s one thing to deal with the demise of the coal industry – clean energy regulations were well flagged and a long time coming. But how do investors protect themselves from increasing numbers of companies being hit with multi-billion dollar fines for environmental, social and governance (ESG) violations?

“The magnitude of fines, and the number of well-known global companies being slapped with them from regulators for violations related to ESG issues is now just too great to ignore,” says Andrew Harmstone, who oversees  some $7.7 billion of assets under management in MSIM’s Global Balanced Risk Control (GBaR) multi asset strategies1. “Clearly, ESG factors are no longer just a moral issue. The market is ascribing value to them, and in some cases they have determined which companies survive and which do not.”

Avoiding Dangerous Waters

The stock markets’ increased focus on these issues is no coincidence. Once it was just the obvious industries, like coal, oil, and textiles, that were exposed to environmental or social backlash. In recent years global corporations in the banking, technology, automotive, retail, oil and gas industries have all suffered from upsets like cyber attacks, or multi-billion dollar fines for environmental or governance violations.

And ESG issues for corporates are likely to grow, now that almost 200 governments have signed the Paris Agreement to slow global warming. That means all equity investors, and not just those in sustainable investing funds, should be looking for ways to reduce their ESG risks, says Harmstone: “We believe that now is the time to begin considering ESG factors in the investment process.”

He believes it's possible to take an ESG investment strategy and merge it with a traditional one. The underlying investment strategy would steer the ship, by dictating where and what to buy, while the ESG analysis would be used to spot potentially dangerous waters at the stock level.

We truly believe a heavy ESG tilt on equity investments should help reduce risk and boost returns.

Tilting

Portfolio managers can still benchmark their performance against an index like the S&P 500, but tilt holdings in each sector towards companies with the strongest ESG ratings.

Analytical tools are now available to give every stock a score of between 1-5, based on their exposure to a potential ESG-related blowup. There are also ways to rate companies for their ESG strength and business opportunities.

Investors can go even further, by adding an activist component. 

“We believe we  would have a duty to work with the companies in which we invest, to influence their behaviour and help them improve their performance – including in ESG terms,” says Christian Goldsmith, a specialist in Harmstone’s strategy team.

That duty is not just for the great good, but for the good of the investors, he argues: “If you agree that superior ESG performance makes a company more attractive from a risk/return perspective, then working with companies to enhance their ESG scores makes complete sense, both for our portfolios and for our clients.”

The challenge is assuring investors, particularly those who aren’t focused on sustainable investing, that overlaying an ESG mandate shouldn't handicap the underlying investment strategy.

“The biggest question we get from investors is whether they would have to sacrifice returns,” says Goldsmith. “The fact is, we truly believe that having a heavy ESG tilt on equity investments should help reduce risk and boost returns."

1. As of 30 September 2016.

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