Scrutinising how firms implement ESG values in practical terms can identify critical risks that ESG scores miss, according to NNIP head of equity specialties, Jeroen Bos.
Bos told Modern Investor this was one of three key findings from research NN Investment Partners conducted with the European Centre for Corporate Engagement at Maastricht University.
‘Our research showed that if you exclude from your investment universe companies that engage in controversial behaviour, it doesn't hurt your performance but actually improves the risk/reward of your portfolio. The finding goes against conventional wisdom, which says that if you exclude companies, your universe becomes smaller and it will cost you performance,’ he said.
Volkswagen case study
Bos, who heads around €18 billion at NNIP, gave an example of how German carmaker Volkswagen had already behaved poorly before the emission scandal broke out. The Hague-based manager said that because he didn’t focus on ESG scores, but instead on actual behaviour, his sustainable funds dropped VW shares ‘way before’ the emissions scandal happened and chose a competitor’s shares to invest in instead.
‘They scored pretty well on ESG partly because they had a lot of ESG policies in place, but in reality they actually showed poor behaviour on several fronts with a lot of small controversies and governance issues.
‘We believe that when companies show an increasing rate of controversial behaviour it often illustrates a larger problem in terms of company culture, be that in terms of governance, safety or how they treat their employees. In the end, that increases the overall risk that something will go wrong at some point,’ he said.
In order to asses bad practices, NNIP looks data from Sustainalytics and MSCI and tries to assess whether a company has seen an acceleration in small controversies.
He added that bad behaviour in a company brought into question the sustainability of the business model and the current profitability.
‘For instance, if you are under-investing in safety or in your employees, it may show nice short-term profits and more attractive valuation multiples today, but in reality you are putting pressure on long-term sustainable profitability.’
Among the other two conclusions of the NNIP research was the finding that large-cap companies have, on average, higher ESG scores than small-cap companies. Investors should be aware of that size bias and ideally adjust the portfolio accordingly. The second finding advised buying companies with highest ESG momentum rather than highest ESG absolute scores (you can read more about these findings in this Modern Investor story).
Impact investing - next big thing
When it comes to the development of the NNIP boutique Bos manages, impact investing may be on the horizon.
‘We are also looking into launching an impact investing fund that focuses on achieving environmental and social returns. We really view this as the next step in sustainable investing and SRI and we also see more and more institutional and retail investors being interested in this.’
Within the equity specialties boutique, Bos currently oversees two sustainable equity funds with around €2.5 billion under management, both from institutional and retail investors.