Shrewd use of analytics and data engineering is key to ESG investment

As social impact and ethical standards become an ever more important driver of global investment, funds that focus on Environmental, Social & Governance (ESG) factors are taking the financial world by storm. But with real value hard to define or quantify, how can investors make the best decisions? The answer lies in sophisticated implementation of data analytics and data engineering.

Introduction to ESG investment

A few years ago, the idea of making key investment decisions around non-financial factors would have seemed eccentric. Not anymore.  ESG investment funds make decisions based – at least in part - on whether a company is helping to make the world a better place to live and work. And it’s big business. 

These funds are worth $17 trillion in the US alone – that’s a third of all professionally managed assets(1). Investors ploughed more than $50 billion of new money into them in 2020, marking the fifth annual record in a row.  A quarter of all money invested in US stock and bond mutual funds follow this profile – up from just 1% in 2014.(2) 

In 2019, a survey from Morgan Stanley found that 85% of investors value sustainability, a 20% increase over four years. It seems investors are willing to trade at least some profit in exchange for sleeping better at night. But increasingly it’s a trade-off they don’t need to make. Morningstar argues that almost three-quarters of ESG indexes currently outperform their peers.   

Why is ESG investment relevant?

In any case, this marks a significant shift from the ‘greed is good’ mantra commonly associated with the world’s financial capitals. So, what’s driving the change?  

A new generation of investors are an important factor. Younger generations, increasingly driven by social purpose and concerned by issues such as climate change and Black Lives Matter, are advancing into decision making roles at asset management houses.   More choice helps, too. Morningstar estimates there are now 400 ESG funds available, a 4x increase over ten years.  

Regulators, governments and the financial establishment are also pointing investment strategies in the same direction:

• The Biden Administration’s focus on global warming will likely provide a boost for ESG funds.

• The World Bank’s Equator Principles require investors to analyse environmental and social risks associated with large-scale development projects. Most leading financial institutions have signed up to the voluntary guidelines.

• In the UK, the Financial Conduct Authority intends to compel listed companies to report climate risks associated with their operations. Likewise many private investors are pushing their portfolio companies to be more transparent about their ESG credentials.

Measuring ESG credentials 

The question isn’t whether to invest in ESG opportunities, it’s how to find the best ones.  

There are several established research firms that rate a company’s ESG credentials. Bloomberg, JUST Capital, Refinitiv and others provide clients with an ESG score that measures a company’s contribution to, or impact on, the planet and society at large.   

The issue for investors is that this information is readily available to anyone wishing to pay for it. That means the best performers are often already overvalued and as a result the opportunity to invest early in the strongest ESG funds is long gone. 

On top of this, there’s concern that existing research methods aren’t the best way to tell if a business is aligned with an investor’s ESG profile. The results often stray into qualitative musings when what’s needed is robust proprietary quantitative approaches.  

Be creative in deploying data analytics 

It’s no wonder that the most successful investors have brought research and analysis in-house. They’ve built sophisticated data-driven models to match investment opportunities against carefully curated ESG criteria.   

This starts with making the most of data that’s commonly available but difficult to analyse at scale. This includes annual reports, management and financial information, compensation schemes and publicly announced corporate sustainability initiatives.  

Once gathered, these data sets can be configured in all manner of ways to provide benchmarks. AI, machine learning, and advanced statistical approaches then identify the best ESG attributes to quantify a business' performance.

A couple of examples. You could create a management quality index that quantifies diversity and inclusion. Or a business index around a company’s recycling efforts or the supply chain’s impact on the environment and local communities.  Automated, bespoke data collection and analysis means this can be done lighting fast, and at scale. 

Use alternative data to enrich your insights 

The most successful ESG investors look beyond investor presentations, Companies House filings and press releases for insights.  

Alternative datasets comprise sources as diverse as online customer and employee reviews, sentiment analysis of investor reports, mobile and satellite tracking, social media intelligence, even internet-enabled geolocation sensors. These can be matched against a company’s own information to understand whether its ESG profile will likely promote or hinder commercial performance.  As you can imagine, this data is harder to collect and is typically less structured. Mining these sources for actionable insights is tough. But the outcomes far outstrip the efforts in doing so. 

There’s no doubt that ESG funds are here to stay. Not only are the winds of politics and regulation blowing in the direction of sustainable investment, a new generation of activist investors are committed to using their capital to affect positive environmental and social change.  

Sophisticated data analytics - focused on collecting the right datasets and structuring in the right way through data engineering - provides investors large and small with the tools to help make the world a better place while delivering strong returns.

References:

1. Forum for Sustainable and Responsible Investment

2. www.morningstar.com/en-uk/company