Identify Risk and Opportunity Through Sustainability Data

Roberto Lampl

Identifying risk and opportunity is a core part of the investment analysis process, whether it is to increase insight into the investment exposure, elevate an engagement strategy or conduct portfolio performance attribution analysis. A company’s risk profile is connected from a top-down perspective to its country of operations and industry focus, and from a fundamental perspective, depends on the execution of its corporate strategy, beginning at the management level and extending to its operations.

Environmental, social and governance performance scores are an optimal tool to appreciate a company’s sustainability strategy and achieve the analytical objectives as an investment professional. Gauging a company’s sustainability profile through an ESG performance score allows for easy identification of companies achieving an industry relevant best-in-class threshold . For example, an ESG performance score could be expressed on a scale of 0 to 100, with 50 representing the best in class threshold, which facilitates cross-industry comparisons.

ESG performance scores are a weighted average of the performance score at each discrete dimension level from a sustainability perspective—environmental, social and governance, their weights determined by the varying materiality of sustainability topics across each industry with an industry-specific rating structure. Multiple factors influence the final weight attributed to individual topics and indicators, including the following:

Recognition of the topic’s materiality by corporate issuers, as well as by external disclosure standards, such as Global Reporting Initiative, Sustainability Accounting Standards Board, Task Force on Climate-Related Financial Disclosures and the Carbon Disclosure Project
Characteristics of the business model, such as exposure to supply chain risks, or the geographic breakdown of operations
Track record of and exposure to controversies
The company’s business exposure towards contributing or detracting of the Sustainable Development Goals

Complementing Financial Statement Analysis

The availability of standardized financial statements facilitates peer comparison on all matters financial. From revenue growth to operational profit margin volatility and capital allocation, as well as ratio analysis to understand debt servicing capacity and investment’s capital return profile. Benchmarking an ESG provider’s ratings data is more complex due to its reliance on qualitative information, the variation in ESG methodology across service providers and the variability in issuer disclosure. A workable sustainability methodology should facilitate a systematic comparison of non-financial data that can elevate an investment professional’s understanding of a company’s sustainability positioning. Sustainability or ESG related data provides insight into the policies, procedures, consistency, and level of commitment related to how a company executes its corporate strategy, thus providing complementary insight into the potential risks and opportunities a company faces, which are not readily apparent from traditional financial statement analysis.

ESG data can be used to identify sustainability related underperformers from outperformers not only at the ESG performance score level or the category level of performance, but also at the industry specific key issue level. These key issues illustrate the industry specific sustainability risks and opportunity connected to a particular issuer, and comparing sustainability related data across an industry provides an appreciation of the distribution of ESG related scores.

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Complementary Insight

Sustainability data can be used to illustrate portfolio positioning beyond industry, country, and market cap allocation. Overlaying company-specific sustainability data enables the investor to compare portfolio positioning relative to its benchmark index, which can be additive to the analysis of its asset allocation strategy. Having access to complementary data in the fundamental analysis process augments the ability to identify risk and opportunity, beyond what is directly evident from traditional financial statement analysis. The charts below illustrate this point, Figure 1 displays data from 97 oil exploration and production companies covered by ISS ESG. Figure 1 illustrates the distribution of performance scores of this group and reveals that less than 5% score at or above 50, the best-in-class threshold from a sustainability risk and opportunity perspective. The columns to its left illustrate the distribution of contributing factor scores, showing that less than 5% have an Environmental Score at or above the best-in-class threshold, while 11% have a social performance score above this threshold and finally 76% have a governance performance score above the prime threshold. Admittedly, scores could simply be an issue of poor disclosure rather than underwhelming practices and policies. However, more frequently it is the case that companies scoring at the bottom lag in their sustainability practices, while companies improving, if we compare their year-on-year progression, could indicate a momentum in their operational performance.

In Figure 2 we illustrate the distribution of the five key issues specific to the oil and gas industry, which are derived from single topics or a combination of several topics and/or indicators of the rating structure. Cumulatively, all key issues account for at least 50% of the overall weight of the scoring model. Comparing a company’s key issue score adds another source of information to identify potential operational risk or opportunity in its value chain. Figure 2 shows business ethics and relations with governments to be the only key issue where the median score is above this industry’s Prime equivalent threshold. Companies that score in the lower quartile could be construed as having a higher risk profile. Key issue 1 on climate protection and contribution to the energy transition and 3 on worker safety and accident prevention indicate that not one company can achieve a score at or above the best-in-class threshold. Access to this data could assist in the fundamental modeling process and provide due diligence ideas in the engagement process. Combining sustainability data at the topic level with key issue data provides a deeper understanding of a company’s sustainability positioning, which may not necessarily be directly apparent to the financial analyst.

Augmenting Performance Analysis

Another use case is to overlay the sustainability data in the performance attribution analysis process to evaluate investment performance, for example, overlaying company-specific sustainability decile or quartile positioning could provide additional insight into this factor as contribution or detraction of investment performance. Overlaying ESG performance data could add value to the risk budgeting process across investment strategies, thus elevating the sophistication of risk analysis by considering an issuer’s sustainability positioning relative to its peers in the context of the data’s dispersion.

In summary, sustainability data can help provide greater clarity by embracing the signals provided by ESG performance and key-issue data in the engagement process, fundamental analysis, performance construction and risk analysis process.

Roberto Lampl is a managing director and sector head for Industrials, Financials & Real Estate at ISS Stoxx. He has more than 30 years of experience ranging from debt capital markets, structured finance, and investment analysis. Roberto’s work extends from developed to emerging markets and has covered all GICS industries while frequently engaging with companies on the implementation of ESG practices.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice.

Tags: Climate Disclosure Project, data and investment analysis, ESG Investing, Global Reporting Initiative, ISS ESG, Sustainability, Sustainability Accounting Standards Board, Task Force on Climate-Related Financial Disclosures (TCFD)

Vanguard is immediately reopening two actively managed stock mutual funds.

On Tuesday the firm announced that it would reopen its Primecap (VPMCX) and Primecap Core (VPCCX), which have been closed off to new investors since 2004 and 2009, respectively. A third Primecap fund, Capital Opportunity (VHCAX), was also closed in 2004 and remains closed.

The two large-cap growth funds have reopened without restriction to all investors and will be available for all new accounts. Primecap had assets of $76.1 billion at the end of May, while Primecap Core had assets of $13.2 billion.

Vanguard routinely closes funds to new investors when it is in the best interest of shareholders, according to a spokesperson for the firm. One thing that the firm evaluates when doing so is whether the size of a fund could impact a manager’s ability to effectively generate alpha for investors.

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“After careful consideration of the funds’ current investment capacity, Vanguard has determined that the funds have sufficient capacity to reopen to new accounts and additional purchase without limit,” the spokesperson said.

Both funds have strong returns, outperforming their benchmarks. Primecap has returned 15788.63% since its inception in 1984, or 13.66% annualized against an 11.6% benchmark and has posted annualized one-, three-, five- and 10-year returns of 29.11%, 27.80%, 108.14%, and 249.48%, respectively.

Primecap Core, launched in 2004, has returned an annualized 11.2% since inception, beating its 10.26% benchmark and over the past one, three, five and 10 years has returned an annualized 28.98%, 8.26%, 15.04%, and 12.42% respectively, against benchmarks of 28.17%, 8.67%, 15.59% and 12.56%, respectively.

Over the last two decades, investors have significantly shifted from actively managed strategies to passive ones. According to Morningstar data, passively managed funds took in $73 billion, while passively managed ones saw outflows of $15 billion in May 2024.

Both Primecap funds are actively managed mutual funds with a long-term perspective, primarily made up of U.S. large-cap equities. Primecap focuses on growth-oriented stocks, while Primecap Core’s portfolio consists of stocks with value and growth characteristics. Year to date, Primecap Fund has returned 14.48%, and Primecap Core has returned 13.11%.

Since the closure of the funds, existing investors have been limited to annual purchases of $25,000. Among those who could still buy the actively managed mutual funds included Vanguard flagship services clients, those with more than $1 million invested in the firm’s mutual funds.

Both funds are managed by Primecap Management Co., an American investment management firm, which has actively managed equity portfolios for Vanguard since 1984.