Interest in investing that incorporates environmental, social, and governance (ESG) factors has grown tremendously during the past few years. More importantly, this interest has quickly translated into rapid growth in the number of funded mandates globally.
The vast majority of these funded mandates appear to be currently focused on bottom-up (or security-selection) strategies, a phenomenon to which our bottom-up-oriented colleagues can attest. They integrate ESG factors into their respective company-specific analyses; their considerations are informed by a proprietary framework to help identify material sustainability risks and opportunities across different industries.
However, we believe ESG principles can also be thoughtfully incorporated through a macro (top-down) approach. It is actually something our team has been doing for years. Even as top-down-oriented investors, we consider ESG integration a natural part of our investment process.
ESG-oriented investing aligns with looking at the long-term growth aspects of potential investments. It considers whether an economic exposure relies on strong and sustainable foundations for growth. As macro investors, we consider the economic foundations of the countries in which we invest, which inherently rely on the promotion of social welfare.
The incorporation of ESG principles in the evaluation of the diversified instruments—such as exchange-traded funds (ETFs) and futures—that we typically use to gain our macro exposures may seem incongruent to some. After all, ESG incorporation is often thought of as solely company-specific in its application and our team generally does not evaluate or invest in company-specific exposures. However, we have incorporated ESG principles as a part of our top-down fundamental valuation model input reviews for most of the past decade.
By seeking to invest in countries with better prospects for growth and more opportunities for innovation and human flourishing, we believe we can make investments both in line with ESG goals as well as in areas where we expect to see the best returns over time.
To illustrate this, let’s look at the three ESG components in turn.
Multiple decades of research have confirmed that one way to promote the environment is through the appropriate development and deployment of economic resources. To wit, countries with extra resources, such as the United States and many in Europe, typically have cleaner air to breathe than poorer countries.
In China, for instance, the air is comparatively unhealthy even though it is slowly becoming cleaner. We are optimistic about China’s efforts to pursue cleaner air as a part of its future economic growth.
In our view, social progress is best promoted through a healthy population, opportunities for personal and professional growth, and the freedom to possess private property and pursue personal development. Such aspects can be captured in various indices measuring things like the ease of starting a business, corruption, and economic freedom, all of which our team monitors and analyzes.
These third-party sources are important data for our assessments of not only areas of specific social progress, but also economic growth generally, on which environmental improvements also rely.
These indices capture the conditions for businesses in an economy and, as such, also encapsulate the third aspect of ESG, governance, which relies on such things as freedom from corruption and wealth-promoting tax systems.
In these ways, by seeking to invest in countries with better prospects for growth and more opportunities for innovation and human flourishing, we believe we can make investments both in line with ESG goals as well as in areas where we expect to see the best returns over time. By using unique measures of the business environment, we aim to capture an economy’s potential economic growth, as well as the three prongs of ESG.
Our assessment of institutional development underpins our country-level fundamental valuation of equity and fixed-income markets around the world.
We monitor changes in the business climates of global economies on a regular basis. Our valuation framework has four distinct horizons, or stages.
Our interpretation of these changes typically influences the first two of these stages. We look at changes in policies to assess economic growth in our “cycle-adjusted” stage, which spans from today to year eight. An even greater emphasis is devoted to our “normalized” horizon, which spans between eight and 25 years in the future. Here, we apply measures of institutional progress, which is where ESG principles have the most influence.
Policy variables cover items such as fiscal health, labor freedom, government burden, and regulation, while institutional variables relate to property rights, judicial independence, and the like. We account for both the most current assessment and longer-term trends.
Our assessment of institutional development underpins our country-level fundamental valuation of equity and fixed-income markets around the world. Because the fundamental value of a market is a reasonably stable phenomenon, we holistically revisit the various inputs to our valuation framework annually. We also revisit inputs more frequently when we observe unexpected or quickly evolving developments that we believe will alter long-term valuation.
Economies that show institutional improvements tend to grow faster and provide better opportunities for businesses to grow their earnings. We expect that this will continue in the future.
By seeking to invest commensurate with economic growth and better opportunities for people to invest, promote their property, and be free from oppression and corruption, we aim to incorporate ESG principles that we believe will also generate the best returns for our clients.
John Simmons, CFA, is a senior investment strategist on William Blair’s Dynamic Allocation Strategies team.