How Investor Demand Is Causing Analysts To Focus on Social and Environmental Risks

In a highly competitive and volatile investing environment, no one can afford to ignore any credible source of data offering potentially significant differentiation in results, especially those which are increasingly popular with clients. JL

Randall Smith reports in the New York Times:

The amount of assets managed using E.S.G. factors has more than tripled to $8.1 trillion since 2010 driven in part by big money managers trying new ways to evaluate potential warning flag(s) for stock-market darlings “with aggressive practices that may be skating too close to the edge.” (And) younger investors like the approach. “It really helps us understand business risks — and opportunities.”

Pfizer stock was riding high in June 2015, up 128 percent in five years, making it the second-most valuable American drug maker. Nine out of 10 Wall Street research analysts recommended that investors hold it in their portfolio, if not buy more.

That same month, however, a different type of research firm downgraded Pfizer to its lowest rating, reflecting what it considered increased risks from factors that other Wall Street analysts typically ignore: environmental, social and corporate governance issues, or E.S.G.

Investing based on so-called E.S.G. factors has mushroomed in recent years, driven in part by big pension funds and European money managers that are trying new ways to evaluate potential investments. The idea has changed over the last three decades from managers’ simple exclusion from their portfolios of “sin stocks” such as tobacco, alcohol and firearms makers to incorporation of E.S.G. analysis into their stock and bond picks.

Sometimes, E.S.G. can be a warning flag for stock-market darlings “with aggressive consumer or product safety practices that may be skating too close to the edge,” said Linda-Eling Lee, global research chief for MSCI’s E.S.G. ratings. For example, MSCI downgraded Volkswagen two notches to its third-lowest rating in 2013 — two years before an emissions-test cheating scandal — in part because of “poor levels of director independence.”

MSCI is perhaps better known for its global stock indexes, but its annual E.S.G. index and research revenues have been growing at 20 percent annually and should top $44 million this year, making the segment the firm’s fastest-growing business.

On Pfizer, MSCI’s research noted the high volume of regulatory warnings that the company had received as of mid-2015, raising the risk of liability concerning five of its drugs. The downgrade caught Pfizer’s attention, and its representatives met with MSCI officials to update them on legal issues like asbestos lawsuits, and about various drugs like Zoloft, Effexor and Protonix. MSCI kept its rating.

The amount of assets managed using E.S.G. factors has more than tripled to $8.1 trillion since 2010, according to a report issued in November by the US SIF Foundation, which tracks sustainable investing. The TIAA-CREF Social Choice Equity Fund has doubled in size to a current $2.3 billion in the last five years. Exchange-traded funds linked to MSCI E.S.G. indexes have tripled to $3 billion in the last three years. And there has been a proliferation of E.S.G. index or research providers, including FTSE Russell, S&P Dow Jones Indices and Sustainalytics, which helps Morningstar rate mutual funds on their E.S.G. factors.

A $2.4 billion Vanguard social index fund, which has quadrupled in size since 2011, uses a FTSE4Good index. A $2.5 billion low-carbon portfolio announced in July by the California State Teachers’ Retirement System will use an MSCI index.

Wall Street firms have jumped in; Goldman Sachs acquired Imprint Capital, an E.S.G.-focused firm, last year and Perella Weinberg Partners manages the Rockefeller Brothers Fund’s fossil-fuel divestment.

Surveys have shown that younger investors like the approach. Calls for fossil-fuel divestment linked to climate-change concerns have also raised awareness. Even the regulatory climate has shifted: The Department of Labor ruled last year that investing fiduciaries could consider E.S.G. factors in their investment decisions as long as they did not hurt expected returns.

Lisa Woll, chief executive of US SIF, said that even if a Trump administration “rolls back progress” on some environmental and social issues, the field over all “is likely to continue to grow based on demand by a wide range of investors.”

Assembled through acquisitions between 2009 and 2014, the MSCI E.S.G. ratings “have come to be the market standard for E.S.G.,” said Amy Orr, the director of capital markets at the Heron Foundation, which pursues an anti-poverty mission.

Photo

The New York Stock Exchange in late November 2015. In June of that year, MSCI downgraded Pfizer stock based on E.S.G. factors. Credit Richard Drew/Associated Press

On a recent morning last month, standing before a computer screen elevated by black metal stilts for videoconferencing, Ms. Lee conducted calls with MSCI analysts in Mumbai, Tokyo, Beijing and Massachusetts to consider a few possible ratings changes.

They first considered whether a Chinese steel company, Fosun International, should be upgraded because it was moving into financial services and would have lower exposure to toxic emissions. “We approve, including the rating upgrade. Thanks, Xiaoshu,” Ms. Lee said to her analyst.

Next was a downgrade of ENN Energy Holdings, a natural gas pipeline distributor in China that had carbon emission issues and what a utility analyst in Tokyo, Kenji Watanabe, called a “weak board composition.” But a downgrade was deferred for Bolloré S.A. — a French transportation company that recently had a rail accident that killed 79 in Cameroon — pending an MSCI effort to reach the company.

The MSCI ratings do not exclude all stocks in any given category, such as fossil fuels or tobacco, but rather rank each company against its peers based on how it manages E.S.G. risks.

In oil and gas, for example, the Norwegian giant Statoil ranks near the top based partly on its record of spills and low emissions, while the American company Chevron ranks near the bottom with higher-risk operations, including forced shutdowns this year of a new $54 billion liquefied natural gas plant in Australia.

The building blocks for MSCI’s E.S.G. research came from acquisitions that included a governance ratings firm co-founded by Robert Monks, a pioneer in shareholder activism, and a socially responsible stock research firm, KLD Research & Analytics, which introduced the Domini 400 Social Index in 1990.

The goal, Mr. Monks said in a recent interview, is to “apply something akin to classical security analysis to areas which have so far escaped consideration in valuing companies.”

Performance does not have to suffer. Although the TIAA-CREF social choice fund and the flagship MSCI exchange-traded fund have trailed the market slightly for the last five years, the Vanguard fund has topped it. The $14.8 billion Parnassus Core Equity Investor fund, which picks stocks using E.S.G. and fundamental analysis, has beaten the market by more than two percentage points annually over the last 10 years.

As E.S.G. becomes more popular, companies have become more responsive to MSCI’s data-gathering efforts. Ms. Lee said the response rate had risen from about 15 percent in 2013 to a current 40 percent. Pfizer, for example, first got in touch with MSCI in 2014.

The TIAA-CREF social choice fund, which aims to invest in E.S.G. leaders, does not hold several well-known stocks based partly on unfavorable MSCI ratings. Among those excluded are Exxon Mobil (for environmental impact management), Apple (labor-management relations and supply chain issues), Facebook (privacy and data security), Amazon (labor-management practices), and General Electric (labor-management practices, military contracting, weapons).

With undergraduate and Ph.D. degrees from Harvard, Ms. Lee came to MSCI through the 2010 acquisition of RiskMetrics Group, owner of the Innovest sustainability research firm. Operating from a 48th-floor glass-walled aerie opposite One World Trade Center in Lower Manhattan, she oversees 150 analysts who follow 6,500 companies in 14 offices worldwide.

Some investors find data from MSCI and others helpful as a starting point beyond the narrower E.S.G. agenda. “It really helps us quickly understand whether there are business controversies or other risks — and opportunities,” said Karina Funk, a co-manager of the $360 million Brown Advisory Sustainable Growth fund.

For example, she said, her firm bought stock in American Tower, a cellular tower company after Brown’s own research found its tower-siting practices exceed standards set by environmental regulators or wildlife management groups, “making them a preferred partner.”