Deciphering the ESG landscape

This article appears in the Fall 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Responsible investing funds are proliferating in Canada. And while more options may be good for clients, additional choices add to the challenge of deciphering funds’ objectives and matching products to client preferences.

In an evolving landscape for responsible investing that lacks common standards, and where even key terms are debated, advisors have their work cut out determining client needs and matching those wishes to products.

“Advisors have a particularly tough challenge because sustainable investing can often be a very personal choice for retail clients,” says Ian Tam, director of investment research for Canada at Morningstar in Toronto.

“It’s very tough to match the needs of retail investors to the types of funds that are available.”

Global environmental, social and governance-themed (ESG) assets hit US$1.06 trillion in the first half of the year. In Canada, there were 114 “sustainable” funds to choose from as of June 30, with assets totalling $8.8 billion, according to Morningstar’s identification framework.

Daniel Straus, director, ETFs and financial product research at National Bank Financial in Toronto, says there are now around 50 ESG ETFs in Canada with more than $2 billion in assets — $1.2 billion of which flowed in during the first half of 2020.

“There’s a whole plethora of products, some of which agree with one another in how they approach things; some of them contrast or complement one another; and some of them disagree,” Straus said.

There’s no universal standard for investments that call themselves responsible, sustainable or ESG. Issuers don’t always make material information available, a July report from Morningstar said, and ESG disclosures are often “inconsistent and non-comparable.”

Responsible investing funds can also have different objectives, mandates and holdings.

Morningstar’s sustainable investing framework breaks products into three main categories: ESG funds, impact funds and environmental sector funds (see below).

While funds can fit into more than one category, 99 of the 116 Canada-based funds that Morningstar identifies as sustainable are considered ESG funds. Impact funds account for 54 and seven are environmental sector funds.

Even determining whether a fund is “sustainable” depends on the criteria being used, and rating companies have different methods. The same goes for the company ratings used to create indexes that sustainable ETFs track.

Alicja Brown, investment advisor at Brown Investment Group of CIBC Wood Gundy in Edmonton, says there are “inherent differences in ratings” that can lead to companies receiving very different scores depending on who’s evaluating.

MSCI, the index provider for most Canada-based ESG ETFs, assesses companies on 37 key ESG issues and monitors controversies to arrive at an overall ESG letter score that’s adjusted relative to a company’s industry peers. Like credit ratings, the scores range from CCC (laggards) to AAA (leaders).

Morningstar-owned Sustainalytics produces an ESG risk score as well as a percentile rank that’s based on companies’ total ESG score relative to industry peers (the top 1% score a 99, for example). The score accounts for a company’s preparedness, disclosure and level of controversy across the three ESG themes.

“Different rating agencies may have separate data sources, independent measurement processes and results, alternate key issues, different treatment of missing data, or conflicting ways of looking at controversies,” according to a National Bank Financial report from earlier this year analyzing ESG ETFs.

This can make for “eye-catching discrepancies” between products, Straus says, or companies with relatively high ratings being included in some funds but excluded from others.

The National Bank report found ESG scores from MSCI and Sustainalytics rarely align for individual companies (though it’s rare that scores vary dramatically).

Straus points to the example of how four large-cap companies are treated differently in two major ETFs. BCE and Thomson Reuters are excluded from the BMO MSCI Canada ESG Leaders Index ETF because of a low rating for Bell on labour management, privacy and data security, and a low “human capital development” score for Thomson Reuters. Both companies are included in the iShares Jantzi Social Index ETF, which uses ESG scores from Sustainalytics.

The iShares fund excludes Enbridge and Bank of Nova Scotia, but those companies are included in the BMO ETF.

“It shouldn’t be surprising that in any index universe with 100 companies, there will be some [cases] where a company gets a higher rating in one and is fully excluded in another — either for some methodological quirk, like an exclusion based entirely off carbon impact, or for some other issue like labour practice or minority representation that may not even be considered in the other index,” Straus says, speaking in general terms.

Advisors, therefore, need to understand the nuances of how rating agencies develop their scores — the data process, how often scores are updated and how they’re vetted — the same way they research company balance sheets and operations, he says.

“There is almost no shortcut for an advisor who wants to use an ESG [fund] other than looking at the index construction methodology and at the portfolio, and then asking if that aligns with the value system and the way they want to invest,” Straus says.

While there is discrepancy between different providers’ ESG scores, Brown says it’s up to advisors to understand the methodology, come up with their own approach and follow it consistently. With clients, she defines which companies stay in portfolios and which don’t meet the mark based on the providers’ scores.

But ratings are only one side of the coin. Advisors also need to understand what their clients really want before they recommend a product. This means identifying which elements of responsible investing are most important: avoiding risks from human rights scandals, supporting companies with strong employee diversity or investing in clean energy — or all of the above.

In response to such concerns, the CFA Institute is developing a disclosure standard for fund companies. The institute has a standard out for consultation (the initial version is expected to be ready in May 2021) that defines six ESG-related features found in products, and identifies five common client needs when it comes to ESG investing. The idea is to develop a matrix for advisors to match client needs to product features (see Table 1, below).

Table 1: CFA Institute’s proposed ESG standards matrix

Click image for full-size chart

The standard will require asset managers to disclose specific information about ESG products. Once asset managers submit a product to the standard, they must comply with the disclosure requirements.

“It’s hard for clients sometimes to articulate their needs,” says Chris Fidler, the CFA Institute’s senior director, global industry standards. “They might not know exactly what they want until they see it.”

Product manufacturers can describe a product’s features, benefits and limitations, he says, but they can’t ensure an investor uses the product in the appropriate way. “That matrix will be the translator between a client’s needs and the benefits of a product.”

Without a common standard, there’s plenty of digging for advisors to do. When building portfolios, Brown starts by identifying funds that identify as responsible to fill out a specific asset allocation, such as U.S. equities. She examines the asset manager’s ESG reports and might book meetings with portfolio managers to learn about shareholder engagement and the underlying investment thesis. She tries to build portfolios with ESG layered in across asset allocations.

Brown, a member of the Responsible Investment Association’s board, used to use passive or best-in-class funds but has moved to mostly active funds that use ESG integration at every step of portfolio construction.

“It takes a deeper dive, but that’s our role as advisors, where we’re getting paid to do a deeper dive,” she says. “We do it on the financial side; we need to do it on the RI side as well.”

Morningstar’s sustainable investing breakdown

ESG funds: ESG risk factors are a central part of the investment process and/or managers actively engage with company management about ESG risks.

Impact funds: Seek to have a measurable impact on topics including the environment, community development, and gender and diversity.

Environmental sector funds: Invest in companies working in areas such as renewable energy, green transportation, environmental services and climate resilience.