Empirically measure ESG impact as tracking error – so you can see it alongside risk and return.

We all know the importance of ESG assets – they’re on track to exceed $53 trillion by 2025, representing more than a third of total assets under management (Bloomberg). It’s no surprise then, that many asset managers have been introducing a wide variety of ESG products to the market.

Like many investment funds however, ESG funds are mainly sold based on the reputation of the management firm, the fund name, and the marketing message linked to the fund itself. Investors may then look to third-party ESG scores to compare these funds, but here they will run into more problems.


ESG ratings: the age-old apple and orange analogy

If ESG funds are rated by different ratings providers using different scoring recipes (rather than using proper ESG data), this makes it almost impossible to compare them. How do you compare a fund with an ESG rating of “A-” to one with a rating of “64/100”?

Well as you might expect, you can’t. These opaque ratings don’t correlate across providers because each provider uses its own methodology and has its own house view on what is good ESG performance. MIT research found the correlation between six major ESG ratings agencies, including MSCI, Moody’s and Refinitiv, to be only 0.61 (on a scale of 0 to 1, with 1 being highly correlated).

So how can we empirically measure ESG?

Impact Cubed Methodology – using ESG data

In its simplest definition, tracking error is a measure of performance that compares the return of a portfolio or fund to its benchmark, measured in basis points or bps. 100 bps = 1% tracking error.

There are various portfolio attributes that contribute to the tracking error – for example, the types of industries represented by the companies in the portfolios, the company locations, etc. But we’ve developed a way to attribute companies’ ESG Impact to tracking error; and therefore a way to objectively measure and report impact, alongside conventional investment measures of risk and return.

We take the tracking error from positive ESG Impact factor exposures and take away the tracking error of negative ESG Impact factor exposures. The result is quantified Net Impact.

The process is simple (although the computation behind it isn’t – we’ve applied for a patent on the process!).

We take the tracking error from positive ESG Impact factor exposures (such as higher gender balance) and take away the tracking error of negative ESG Impact factor exposures (such as lower board independence). The result is quantified Net Impact, measured in basis points. The more positive the figure, the greater positive impact the fund has vs its benchmark – the opposite is true the more negative the figure. This ESG data is key.

To help investors further, we report the ratio of net impact to overall tracking error. A high ratio shows that a fund has significant impact compared to its benchmark for the tracking error. This means it’s easier for investors to pick more sustainable funds that have similar risk profiles.

Try doing that with opaque ESG scores!

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