Fully integrating ESG factors into a new or existing investment process takes time and often requires trial and error. Many variables are involved and approaches differ between organisation and even between teams.

The first step, applicable to all investors, is to get senior management buy-in regarding the benefits of integrating ESG factors into investment processes. If senior management does not believe that integrating ESG can add value, it is unlikely that sufficient budget for resources and personnel will be allocated for it to have an impact on investment decisions.

Structuring teams

There are two common options for incorporating ESG integration into the organisational structure:

Integrated investment teams

Portfolio managers and investment analysts conduct the ESG analysis and integrate it into overall investment analysis and decisions. Portfolio managers must allocate a sufficient amount of time to researching ESG issues and the latest ESG themes, and they may choose to receive training to deepen their understanding.

ProsCons 
ESG factors are included within the portfolio manager’s research, alongside other material investment risks and opportunities. Portfolio managers may not have time to conduct comprehensive ESG research.
ESG issues are included in discussions, alongside other material investment risks and opportunities. Portfolio managers may not be sufficiently familiar with ESG issues and trends to identify material ones.
Engagement activities on ESG issues will include portfolio managers. Portfolio managers may not have time to engage with companies on ESG factors.

Dedicated ESG team and investment teams

An ESG team conducts the ESG analysis, which the investment teams integrate into overall investment analysis and decisions.

The environment must be conducive to openly sharing and debating ESG and investment research and information amongst the teams, especially on ESG materiality and ESG impacts on investment valuation and decisions. There should be consistent, timely and proactive communication between the teams, which can be helped by regular meetings between teams and close proximity.

Pros Cons
Investment manager will have employees who advocate ESG integration. ESG team may not have buy-in from the portfolio managers.
Comprehensive ESG research conducted on all investments in the investible universe and portfolio. Portfolio managers may not read the ESG analysis performed by the ESG team.
ESG team can liaise with equity analysts for a more holistic approach to ESG analysis. The ESG research may not be in a form that the portfolio manager can integrate into valuation models.
Engagement activities on ESG issues will be performed. Portfolio managers may not be aware of the engagement activities being carried out by the ESG team.

A third structure is emerging, featuring a dedicated ESG team, investment teams and integration specialists who sit alongside the portfolio managers. These integration specialists can be either ESG specialists, investment analysts or portfolio managers specifically assigned to integrating ESG factors into analysis.

Sharing data

However the teams are structured, combining resources provides a holistic picture of all the material factors that can impact a portfolio. It can also improve dialogue between the ESG team and investment teams, increasing the ESG team’s understanding of stock selection, portfolio construction and other financial drivers, and ensuring that the investment team analyses the ESG research that’s been carried out.

One way to combine resources is to use dedicated ESG research sheets (or include a section on ESG research and scores on traditional research notes/stock sheets). These can be discussed in meetings and can feed quantitative ESG information into internal systems where analysts can examine ESG data and other financial data side-by-side.

An alternative method is to create centralised databases and dashboards, where both teams can access traditional financial data, ESG data and valuations.

Reviewing research

As with any research, company and sector ESG research is driven by market events and should be regularly reviewed to identify new and unknown ESG risks and opportunities in the portfolio and the investment universe.

As there can be a large amount of ESG research that needs to be reviewed, this can be time- and resource-intensive, especially for an ESG team covering multiple investment desks and portfolios/funds.

One way to review existing ESG research is through regular sector meetings where investment professionals and ESG specialists discuss news, modifications to companies’ business models and changes to ESG research, ESG ratings and investment valuations.

Another method is to review product and service changes, new controversies and/or changes to ESG ratings by external ESG research providers.

Periodically reviewing which ESG issues are most material for each sector is necessary to ensure all research that evaluates companies’ exposure to those issues remains relevant.

In addition, there should be a review of the impact of ESG factors on valuations.

Structural reviews of the research process and organisational architecture should also be regularly undertaken to ensure that ESG integration practices best respond to underlying market movements and client demand.

Monitoring risk

The portfolio manager will need to regularly review the portfolio (including monitoring the ESG profiles of individual holdings) to remain aware of its ESG risk levels (in absolute terms and relative to the chosen benchmark), and to adjust accordingly to avoid or offset holdings with large ESG risks.

Portfolio monitoring can encourage internal discussion on holdings and the wider investment universe.

Analysing performance

Some portfolio managers are examining the impact of ESG factors on portfolio returns, as part of the common performance review process.

Portfolio managers will either carry out a performance analysis on their own portfolio or a dedicated performance team will be measuring, evaluating and attributing investment performance of all portfolios managed by their investment firm.

A performance contribution analysis can be used to measure the impact of ESG factors on a portfolio’s total return.

Multi-factor performance attribution analysis to extract the excess returns of the portfolio over its benchmark by size (the excess returns of small-cap over large-cap), value (the excess returns of value stocks over growth stocks), environmental factors, social factors and governance factors.

Integrating active ownership practices

Integrating active ownership practices into investment decisions is one of the most difficult features of a fully integrated investment process to get right. When voting and engagement is carried out, this is often initiated by the ESG team and service providers and can be detached from the investment process, leaving the portfolio manager unaware of engagement activities/outcomes and voting choices. Also, ESG considerations should be included, but rarely are, in the existing communications used to evaluate investee companies, such as roadshows and analyst meetings. This can result in there being little-to-no impact on stock selection and portfolio construction.

For an organisation using a dedicated ESG team, some of the tools and processes mentioned above will help, such as regular cross-team meetings and the inclusion of active ownership data in shared resources. Portfolio reviews and risk monitoring tools can be used to identify portfolio holdings with high ESG risks, which are then selected for engagement and/or for voting decisions. Best practice ESG-integrated investment processes will have a mechanism to rebalance portfolio holdings to reflect investee companies’ level of interaction/response to, and/or the outcome of, engagement.

Another best practice feature is a procedure where active ownership practices are linked not just to current holdings but also to potential future investments. This can have a big impact on companies’ behaviour, mitigating reputational risk and improving the ESG profile of the portfolio.

In all cases, engagement and voting activities should have long-term objectives, and portfolio managers and ESG specialists should work with company boards and senior management teams to continually encourage them to improve their firms’ performance.