ESG factors can be integrated throughout a listed equity portfolio, right across the active-to-passive spectrum.

As the level of human intervention and judgement changes from the active to the passive end of the spectrum, so the application of integration techniques tends to move from the stock level to portfolio level. To achieve stock-level integration in quantitative and fundamental strategies, managers and analysts commonly adjust their forecasted financial statements and/or their models to reflect material ESG factors. (There are a few advanced active managers that do integrate ESG factors at the portfolio level.) To integrate ESG factors at the portfolio level in enhanced passive and smart beta strategies, managers tend to adjust the position size of shareholdings, in some cases to zero.

We examine techniques for integrating ESG considerations in the following investment strategies:

The integration model

The PRI defines ESG integration as “the systematic and explicit inclusion of material ESG factors into investment analysis and investment decisions”. It is one of three ways to incorporate responsible investment into investment decisions, alongside thematic investing and screening. All three ESG incorporation practices can be applied concurrently.

The model on the next page illustrates how ESG integration can be applied across investment strategies.

There are four stages to the integration model, which involve the following activities:

  • Stage 1: Qualitative analysis – Investors will gather relevant information from multiple sources (including but not limited to company reports and third-party investment research) and identify material factors affecting the company.
  • Stage 2: Quantitative analysis – Investors will assess the impact of material financial factors on securities in their portfolio(s) and investment universe and adjust their financial forecasts and/or valuation models appropriately.
  • Stage 3: Investment decision – The analysis performed in stage 1 and stage 2 will lead to a decision to buy (or increase weighting), hold (or maintain weighting) or sell (or decrease weighting).
  • Stage 4: Active ownership assessment – The identification of material financial factors, the investment analysis and an investment decision can initiate or support company engagements and/or inform voting. The additional information gathered and the outcome from engagement and voting activities will feed back into future investment analysis, and hence have an impact of subsequent investment decisions.

In the following sections, guidance and case studies explain how ESG factors can be integrated into Stage 2 quantitative analysis across fundamental, quantitative, smart beta and enhanced passive strategies, providing examples of integrating different environmental, social and governance factors into companies from several sectors.

The ESG integration model

The ESG integration model