ESG: broadening morals but narrowing options?

By excluding the lowest ESG performers from the investable universe, investors might limit their opportunities. Genuine concern or mere speculation? Discover how quality factors could offer a solution to this dilemma.

ESG’S boom and gloom

As of late, no one can deny the increasing interest from investors in ESG. ESG AuM are expected to reach USD 33.9 trillion by 2026 with a share of overall AuM increasing from 14.4% in 2021 to more than one-fifth of all assets (21.5%) in 2026 [1].

However, ESG investing is not without its critics, some of whom argue that ESG does not fully live up to its purported merits. To them, the perceived advantages of ESG may be accompanied by often-overlooked limitations.

Investment strategies that focus on ESG factors often rely on a process of ‘exclusion’ or ‘omission’. For instance, at DPAM, all our Article 8, 8+ and 9 strategies systematically exclude companies that are involved in controversial activities, in severe controversies, as well as those misaligned with international global standards. And such approaches purposefully remove bottom ESG performers from the investable universe. This sets a clear and definitive baseline for environmental, social and governance safeguards throughout our offering.

While this process obviously heightens the percentage of high-scoring ESG performers within a universe, it also significantly limits the number of companies in which a strategy can invest. In fact, by side-lining certain industries and under-performing ESG entities, and by purposefully restricting the scope of investments, there's a palpable fear such approaches could curb the broad-based opportunity set and dampen diversification – potentially leading to subdued performances.

Isn't it only logical, then, to ask: to what extent are investors willing to compromise? ESG filters, while admirably seeking to promote ethical standards and sustainability, also inherently narrow the investment playground. The direct consequence of ESG screening processes is that choices become more limited. And in the world of investment, can such limitations be overlooked? Is the trade-off between ESG alignment and investment diversification just a theoretical debate or is it also a tangible challenge that asset managers must navigate going forward?

The hidden harmony of ESG & quality

While cutting out a chunk of your investable universe to benefit from ESG might sound counterproductive at first – it actually doesn’t always need to be. For one, ESG omissions aren’t always as restricting as they appear. In fact, for investors focused on quality factors, ESG factors often align remarkably well with what one might consider hallmarks of quality companies – Upon closer examination, there is actually a significant overlap here.

But what drives this convergence? To understand why quality companies and ESG have so much in common, let’s first have a brief look at what defines ‘quality factors’: They generally refer to companies that can consistently compound shareholder capital at a superior return on invested capital (ROIC) over the long term, which in turns generates greater share price returns for investors who are willing to hold on for the long term. The main drivers for superior ROIC are businesses with secular tailwinds and competitive advantages, leading to a lower competition and higher pricing power. These companies are generally also managed by exceptionally-skilled individuals. Quality companies are generally more predictable, have a more conservative balance sheet and better and more stable cash generation, resulting in lower risk profile and less volatile but higher financial returns.

It turns out that these factors tend to be prevalent amongst high-scoring ESG companies as well. By dissecting the individual components of ESG (i.e. Environmental – Social – Governance), we get a clearer understanding of why the two have so much in common.

E - Environment

Companies that take proactive measures towards reducing their carbon footprint, investing in green technologies, and minimising waste, not only signal a forward-thinking approach, but are also better positioned to adapt to future regulatory changes, market shifts, and resource scarcities.

In short, quality businesses that have proven to be adaptable to change while still focused on delivering superior financial performance are also, implicitly and explicitly, accounting for the risk and return associated with issues such as environmental shifts.

Not only that, but the surge in global environmental considerations can also provide a steady boost and secular tailwind for high-quality businesses such as Kingspan in insultation, Trane Technologies in HVAC, and Epiroc, which champions the electrification of the world.

S - Social

The 'Social' pillar in ESG underscores the importance of human capital, societal impact, and customer satisfaction. Companies that value their employees, prioritise their well-being, and offer professional development opportunities often experience lower turnover rates, higher employee satisfaction, and increased productivity. By fostering a positive work culture, such companies also tap into improved innovation and collaboration, essential drivers for long-term success and steady, continued growth. Again, these are factors that are often present in quality companies.

The reverse holds true as well: enterprises that companies that do not conduct proper due diligence and fail to identify child labour or forced labour across their supply chains face reputational damage but also bear financial risks. When projecting the company's future growth, one must consider the sustainability of its labour source and its effect on profit margins.

G - Governance

Good governance goes hand-in-hand with corporate stability and long-term resilience. Sustainability of financial returns can only be achieved by companies incorporating strong corporate governance principles. Having a proper board structure that is independent, and executive remuneration linked to company performance not only scores strongly on an ESG basis, but also supports strong capital deployment in the best interest of shareholders. Taken together, strong capital allocation, talented personnel, and robust corporate governance are interlinked, ensuring aligned interests.

Quality companies are often identified based on historical financial metrics. Strong corporate governance ensures the sustainability of those metrics in the future.

Breaking ESG boundaries

In short, prioritising quality factors typically leads to a selection from a pool of predominantly ESG-focused companies. This can soften or even remove the potentially limiting impact of a supposedly restricted ESG universe. And that’s not just words, there’s data too. A recent study indicates that 75% of the outperformance in ESG strategies can be attributed to these quality factors [2] – meaning that, while ESG and Quality could have been seen as different, decorrelated factors, this study emphasises the strong interrelation and overlap across the two.

By looking at our own investment strategies within DPAM, the connection between ESG and quality factors is further confirmed. Within our global high-quality universe [3], only a modest 17% of companies fail to meet our ESG criteria. However, when we look at a broader group of companies in our global benchmark constituents, a larger 29% don't align with our standards. This means that, in this broader, non-quality-focused group, companies are 70% more likely to miss our ESG criteria - clearly showing that quality companies are generally more likely to inherently integrate ESG factors in their strategies.

Connection ESG & Quality Factors

Source: DPAM, 2023

To conclude, the notion that ESG limits diversification and performance is largely unfounded, . By carrying out in-depth sustainability analyses, a proper ESG investor also influences the companies in which they invest in through active engagement and proactive voting during AGM's. The latter enables the asset manager to impact its investments in a sustainable fashion. Moreover, ESG factors allow investors to get a clearer view on the opportunities and risks associated with potential investments. This rings especially true for investors focused on quality factors. Though the approaches to identify high-ranking companies might differ, in the end, both ESG considerations and quality investing seek to protect investors against long-term downside risk. Quality companies are reinvesting their capital at a return on invested capital higher than their cost of capital, leading to value creation and capital appreciation. Competitive advantages, barriers to entry, predictability, and higher margins are also supporting the defensive character. Meanwhile, companies that avoid ESG issues also prevent capital losses, either from fines, reputational damages or because investors are hesitant to provide them capital. This common objective clearly explains the interconnectedness between both quality and ESG. In the end, the companies that are removed from the investable universe by restrictive ESG strategies are usually also those that professional quality investors would disregard as well.

[1] 'Exponential Expectations for ESG’, last retrieved from harvard.edu

[2] ‘Honey, I shrunk the Alpha’, Scientific Beta – April 2021, last retrieved from link

[3] Defined quantitatively, to remove any selection bias, based on debt, ROIC, FCF variability and volatility threshold.