ESG investing: Closing the gap with alternative data

The financial goals of investors today go beyond the traditions of securing retirement income, passing on a legacy and growing a rainy day pot. A key motivation that has been on the incline is investing in companies that show exemplary environmental, social and governance (ESG) practices. The many corporate disasters that we’re aware of, that continue to take place and negatively affect the world may be one of the reasons for a shift in mindset when it comes to investing. In 2015, international agreements were made to adopt the UN 2030 Sustainable Development Goals (SDGs) which are made up of 17 ambitious goals which aim to create, by 2030, a “world free of poverty, hunger, disease and want, where all life can thrive.” Financing this sustainable growth effectively means aligning global economic policies and financial systems with it and developing sustainable finance and investing strategies. Many corporates today report on the SDGs, though there is still no standard across the board that provides a benchmark for comparison.

Considering environmental, social and governance performance alongside financial metrics has become a focus for both institutional and individual investors, with investors in the UK investing an average of £124m a week into UK ESG funds in 2019. In 2020, ESG investing is estimated to total over $20 trillion in assets under management (AUM), or about a quarter of all worldwide professionally managed assets. The performance of ESG funds cannot be sniffed at either - the majority of them outperformed the wider market over 10 years, debunking the myth that it’s not possible to turn a profit with ESG. In fact, it’s predicted that one in three European private equity funds will be focused on ESG investing by 2030.

With the threat of climate change growing each day, there is a consensus that the world needs to act now to avoid major impact. There is a growing recognition from the financial services industry that long-term sustainable investment and considering climate risk during investment decision making is important. During 2020 and Covid-19, investors seem even more interested in understanding how companies have responded to the crisis in ESG terms. Many businesses have been critiqued for the treatment of their staff, shareholders and customers, essentially highlighting Coronavirus as a catalyst for ESG investing.

How does ESG investing work?

ESG isn’t the only form of investing focused on giving back to society or making a difference. There are other types, for example, ethical investing or socially responsible investing (SRI) which was the original type of ‘investing for good’. It focused on screening companies and excluding them based on whether significant company profits came from: tobacco, alcohol, gambling or weapons, or whether the company used child labour or animal testing. Typically, funds focused on ethical investing were generating lower returns and had higher risk than those without such exclusion criteria. Nowadays, this has changed and ESG can bring about healthy returns for investors, whilst giving back to society.

ESG consists of exclusions similarly, but is also based on companies meeting desired ESG issues that impact positively within the three factor areas. In the European Union, it’s now compulsory for companies with more than 500 employees to report on certain ESG data publicly, making sustainability datasets from third party companies readily available. The first step an investor takes is to identify which key metrics that they want to focus on within their portfolio. It may be that a single ESG score gathered from a database and assuming a common set of ESG values is acceptable to one investor but not to another. Investors can compile their own metrics and then score companies on ESG factors by analysing multiple data sources, both publicly reported and privately. There are multiple commonly used ESG frameworks that have been developed internationally as performance indicators and with little consistency in the terms being used, investors are struggling to understand the investment opportunities. If investors were speaking the same language or using the same framework, evaluation of investments would be more accurate and complete.

Now that ESG qualities are no longer a “nice to have”, the positive impacts of investing in companies who show their long term commitment to sustainable growth cannot be ignored. If businesses who are driving positive change receive the bulk of investment, they’ll be able to grow faster and do “better” business, showing accountability for their actions.

The relationship between alternative data and ESG

Alternative data adoption in investing is a way of collecting diverse intelligence that can potentially be used to outsmart the market and derive higher profits. It can include social media data, news feeds, payment information, online forums and even satellite imagery amongst other data sets. Within ESG investing, alternative data is gradually being utilised by fund managers to gain insight and generate alpha.

Hedge funds were the original users of this type of data intelligence, and these days private equity firms as well as other fund managers are using it as part of their strategies. It’s certainly a growing trend amongst various investment firms, with JPMorgan estimating $2 billion to $3 billion in spending by asset managers on alternative data (2017).

The growth of our digital world is exponential; worldwide data is expected to hit 175 zettabytes by 2025. In order to analyse these kinds of volumes of data, we rely on building machines and artificial intelligence technology to quickly analyse information from feeds and scrape websites including the analysis of unstructured data.

The reason why alternative data is so relevant to ESG investing is due to the discrepancies in the reporting frameworks, therefore fair evaluation is difficult. Alternative data can fill the gap by providing research that goes beyond what is reported officially by the company in question.

What are the challenges of alternative data?

An incredible amount of data that could be interpreted to make investment decisions is available publicly. The issue of going through all of it to understand what’s relevant and what’s not is a different story - and it’s where AI and machine learning fit in. Whilst implementing this technology can be a challenge, it effectively results in investors gaining access to information that the market doesn’t yet have - which they can act upon swiftly and drive higher returns.

Another challenge of collecting alternative data to analyse for ESG purposes is that not all data sources are equal. Online chats may not all signal the real investor sentiment, with research suggesting that small closed communities may offer better alpha-generating ideas than open communities, which may have a lot of ‘meaningless noise’.

There’s a certain art to understanding and gaining valuable insights from alternative data that involves a mix of humans and machines that can automate the analysis of huge amounts of data. Investment managers should be utilising the talents of specialist data professionals and bespoke software, alongside their analysts and portfolio managers, who can get the heaps of data into a manageable state.

What’s next for ESG and alternative data?

One option is to work with an external data provider, which could be a SaaS solution, focusing on providing an alternative data feed that can be used across multiple roles within an investment organisation. It would integrate traditional financial metrics with alternative data and ESG data, encompassing a flexible data architecture that is scalable in processing, with many data types coming from different sources. Investment managers who are utilising machine learning can potentially build algorithms to identify what information is useful. Within an analytics platform, insights could be gleaned to enhance investment decision making. Once this is in place, companies that are being analysed will be completely focused around the specified criteria, ensuring that portfolios do not stray away from the agreed requirements that have been set.

Those who belong to multidisciplinary environments and are equipped with the knowledge that technology has brought us, have the ability to cut through the noise and make better returns. They’ll be the ones to utilise multiple datasets and make truly data-driven insights that consider risk management, alongside ESG requirements, whilst generating alpha. Those who do not take this approach, are likely to miss out on creating the profit and feel-good factor associated with ESG investing.

What about other forms of sustainable finance?

Investing in companies with good environment, social and governance practices isn’t the only way to invest in businesses that do good. Impact investing is investing in companies that generate measurable, beneficial social or environmental impact alongside financial return, making them proactively intent on positive impact. An example of an impact investment could be investing in a renewable energy business. It’s estimated that over 1,720 organisations manage USD 715 billion in impact investing assets under management as of the end of 2019.

There are many international initiatives furthering green and sustainable finance. Green bonds are bonds that specifically raise money for climate and environmental projects. They come with tax incentives to enhance their attractiveness to investors and were first. The changes that are taking place show a long-term, fundamental shift in how businesses need to operate with not only shareholder profit in mind, but with lasting purpose.