Large caps are the dominant component in funds with an ESG label and individual investors also tend to buy such assets. Taken together, this can lead to a dangerous bubble, says Carole Millet in an essay for finews.first.
This article is published on finews.first, a forum for authors specialized in economic and financial topics.
We know companies have not sufficiently prepared themselves for the mounting regulations and shareholder pressure they will face under an intensifying ESG lens. If firms have failed to evolve their businesses, they will see a deep impact on performance.
Indeed, we are already seeing value destruction ignited by ESG issues. In the wake of January’s deadly Vale’s Brazilian mining disaster that claimed 240 bodies, Sustainalytics, the ESG ratings agency, immediately pulled their recommendation. The stock price plunged by -28 percent which contributed to a price plunge of 28 percent.
«This could lead to a dangerous bubble»
We are encouraged that pressure is mounting on companies to improve their ESG metrics. However, we believe the hot money flowing into companies with a higher ESG score is stoking a bubble. For us, ratings are a crucial part of the investment process if you are integrating ESG risk, but they are only one tool that investors can utilize.
If investors adopt a herd-like mentality and only invest in large-cap best-in-class companies displaying the highest ratings, it can lead to valuations getting detached from reality. Larger capitalizations currently dominate ESG-labelled funds and investors often invest – without realizing it – in the same way, multiplying risk. This could lead to a dangerous bubble and impede the global transformation to more sustainable investing.
Sustainable long-term investment must combine analytical ESG tools such as ratings, and fundamental bottom-up active investing to analyze where cash generation and return on equity can justify valuations.
«Applying ESGs in fixed income is not an easy task»
While the integration of ESG is less prevalent in the fixed income space, asset managers are beginning to make strides in the bond world. We have collaborated with the World Bank and issued two bonds linked to the UN’s Sustainable Development Goals (SDGs). Applying ESGs in fixed income is not an easy task: between governments and companies, we must consider all the complexity and myriad factors of debt issuance.
To affect positive change, we must assess the impact and exercise engagement. But even then, as bond prices remain sensitive to currency and external factors, it remains a deeply complex task. However, recommending a bond just because it bodes well for a portfolio return objective is no longer acceptable. Embracing sustainable investment is not a race in the fixed income world it is about making incremental gains through a combination of analysis and engagement.
«Ignoring smaller firms in the sustainable chain avoids a rich vein of alpha opportunities»
The consideration of ESGs ratings is a must, not only in managing investment funds but also in the advisory functions. Plugging the non-financial data into traditional analysis adds value, but it is important to walk the extra mile. For us, this means understanding what are the future challenges a company might face and how they will affect earnings.
The exercise becomes more onerous when we consider smaller-sized companies, as most are chronically under-research by analysts. But ignoring smaller firms in the sustainable chain avoids a rich vein of alpha opportunities, as micro and small caps are the cradle of entrepreneurs.
«Ultimately it must start with good governance»
Many offers today are packaged around environmental issues – something which is increasingly aligned to investor objectives. For example, if we want to be active and successful in fighting climate change, we need to think creatively and design new products that will reward investors – the basic principle of – and support companies that want to pass down a better future and a healthier planet to the next generation.
Ultimately it must start with good governance, and a real motivation to reduce societal and environmental impact. But it must be borne in mind, that it is always more difficult to maintain a high ESG rating score than reshaping a company to improve a low score.
As Syz, we decided to embrace the change by inviting our clients to express their views and requirements in sustainable finance. Huge differences exist between regions, culture and personal aspirations. Understanding the origin of our clients' capital and their source of revenues is helping us to design customized portfolios to prevent risks in an increasingly homogenized market and address the great problems of our age.
Carole Millet is a senior investment advisor and in charge of the responsible investments’ offer at Banque Syz.
Previous contributions: Rudi Bogni, Peter Kurer, Oliver Berger, Rolf Banz, Dieter Ruloff, Werner Vogt, Walter Wittmann, Alfred Mettler, Peter Hody, Robert Holzach, Craig Murray, David Zollinger, Arthur Bolliger, Beat Kappeler, Chris Rowe, Stefan Gerlach, Marc Lussy, Nuno Fernandes, Richard Egger, Maurice Pedergnana, Marco Bargel, Steve Hanke, Urs Schoettli, Ursula Finsterwald, Stefan Kreuzkamp, Oliver Bussmann, Michael Benz, Peter Hody, Albert Steck, Martin Dahinden, Thomas Fedier, Alfred Mettler, Brigitte Strebel, Peter Hody, Mirjam Staub-Bisang, Nicolas Roth, Thorsten Polleit, Kim Iskyan, Stephen Dover, Denise Kenyon-Rouvinez, Christian Dreyer, Kinan Khadam-Al-Jame, Robert Hemmi, Anton Affentranger, Yves Mirabaud, Katharina Bart, Frédéric Papp, Hans-Martin Kraus, Gerard Guerdat, Mario Bassi, Stephen Thariyan, Dan Steinbock, Rino Borini, Bert Flossbach, Michael Hasenstab, Guido Schilling, Werner E. Rutsch, Dorte Bech Vizard, Adriano B. Lucatelli, Katharina Bart, Maya Bhandari, Jean Tirole, Hans Jakob Roth, Marco Martinelli, Thomas Sutter, Tom King, Werner Peyer, Thomas Kupfer, Peter Kurer, Arturo Bris, Frederic Papp, James Syme, Dennis Larsen, Bernd Kramer, Ralph Ebert, Armin Jans, Nicolas Roth, Hans Ulrich Jost, Patrick Hunger, Fabrizio Quirighetti, Claire Shaw, Peter Fanconi, Alex Wolf, Dan Steinbock, Patrick Scheurle, Sandro Occhilupo, Will Ballard, Michael Bornhaeusser, Nicholas Yeo, Claude-Alain Margelisch, Jean-François Hirschel, Jens Pongratz, Samuel Gerber, Philipp Weckherlin, Anne Richards, Antoni Trenchev, Benoit Barbereau, Pascal R. Bersier, Shaul Lifshitz, Klaus Breiner, Ana Botín, Martin Gilbert, Jesper Koll, Ingo Rauser, Carlo Capaul, Claude Baumann, Markus Winkler, Konrad Hummler, Thomas Steinemann, Christina Boeck, Guillaume Compeyron, Miro Zivkovic, Alexander F. Wagner, Eric Heymann, Christoph Sax, Felix Brem, Jochen Moebert, Jacques-Aurélien Marcireau, Peter Hody, Ursula Finsterwald, Claudia Kraaz, Michel Longhini, Stefan Blum, Zsolt Kohalmi, Karin M. Klossek, Nicolas Ramelet, Søren Bjønness, Lamara von Albertini, Andreas Britt, Gilles Prince, Fabrizio Pagani, Darren Willams, Salman Ahmed, Stephane Monier, and Peter van der Welle, Swetha Ramachandran, Beat Wittmann, Ken Orchard, Michael Welti, Christian Gast, Didier Saint-Georges, Jeffrey Bohn, Juergen Braunstein, Jeff Voegeli, Gérard Piasko, Fiona Frick, Jean Keller, Stefan Schneider, Lars Jaeger, Matthias Hunn, Andreas Vetsch, Teodoro Cocca, Fabiana Fedeli, Claude Baumann, Marionna Wegenstein, and Kim Fournais.
