ESG Investing Part 3: ESG Across Asset Classes and in Asset Allocation
The tremendous increase in the share of intangible assets (relative to tangible assets) in the total value of corporations over the last few decades implies greater value for the information that can be captured through ESG analysis, and is an important reason why ESG (environmental, social, governance) data-points are extremely value additive in investments and portfolio construction. ‘G’ was the earliest ESG data point to be used and is probably the pillar most priced-in, and there is increasing awareness that along with the other pillars (E and S), lead to stronger corporate operational performance, and hence impacts financial instruments. The use of ESG data started in equities and is now gradually spreading across corporate bonds, in investment grade and high yield. Research results indicate that while ESG may be an alpha indicator, but it is definitely a risk indicator, particularly tail risk. Given the asymmetry in return potential for equity versus fixed income, this indicates that even more than in equities, ESG data points have lot of value in fixed income investing. ESG integration is expanding across newer areas in fixed income – sovereign bonds, municipal bonds, emerging market debt, structured finance, banks loans, and in real assets. The research analyzes recent empirical studies to document the predictive ability of ESG data on credit and sovereign risk over and above what is captured in credit ratings. The value of ESG in multiple asset classes implies that they can be used not only in bottom-up security selection, but also in top-down asset allocation. The simplest way to integrate ESG in asset allocation would be to use the empirical results on how ESG impacts returns and risk in different asset classes, to accordingly adjust the capital market assumptions for return and risk (including the asset class correlations) in different asset classes.