The Evolution of Responsible Investing: A Focus on Materiality and Client Needs

Published: 10-10-24
Submitted by: AllianceBernstein
Author: Erin Bigley, CFA, Chief Responsibility Officer

In the ever-evolving landscape of finance, Environmental, Social, and Governance (ESG) issues have emerged as pivotal considerations for investment firms and their clients. As we look to the future, it is clear that the focus will increasingly be on material issues and the changing needs of clients. Responsible investing is not merely a trend; it is a fundamental shift in how investment strategies are developed and implemented.

The Pendulum of Responsible Investing

Responsible investing has oscillated between enthusiasm and skepticism over the years. While there was a surge of interest in integrating ESG factors into investment strategies, recent years have brought a reality check. Investment firms and clients are now grappling with a myriad of challenges, including regulatory pressures, research complexities, political influences, and the imperative of portfolio performance. Despite these challenges, the integration of financially material ESG factors into investment practices is here to stay.

Understanding Client Preferences

At the heart of the current ESG challenge lies the diverse spectrum of client preferences and perspectives. The pressing question for global investment firms is: How can we develop an ESG framework across various asset classes that caters to these varied needs while enhancing our ability to deliver optimal outcomes for clients?

The Role of Fiduciary Responsibility

Fiduciary responsibility is the cornerstone of every asset manager’s decision-making process. However, when it comes to responsible investing, the implementation of this responsibility can take various forms. Asset managers should offer a range of portfolios that employ different investment approaches to meet the diverse needs of clients.

A unifying principle is essential: grounding all ESG efforts in materiality. This means that portfolio managers must analyze issuers and securities based on a comprehensive set of financial factors that could materially impact risk and reward potential. ESG issues that could positively or negatively affect a business and its securities must be integral to this analysis. Ultimately, this approach aligns with the fundamental tenets of good investing.

The Interconnected Nature of ESG Issues

Many ESG issues present both risks and opportunities for companies. For instance, businesses that utilize forced labor in their supply chains may face significant repercussions, including import bans. Similarly, natural disasters—ranging from hurricanes to droughts—are becoming increasingly frequent and costly, posing material risks to companies across various sectors.

Biodiversity, too, is emerging as a critical issue, as the pressure on Earth’s resources intensifies. The rapid advancement of artificial intelligence (AI) brings its own set of ethical dilemmas, from energy consumption to potential job displacement. Furthermore, corporate governance practices can significantly influence broader business outcomes. Recognizing that material ESG risks and opportunities are often interconnected is vital for enhancing decision-making and client outcomes.

The Importance of Materiality in ESG Integration

As regulatory scrutiny increases globally, companies that fail to comply with ESG-related regulations may face reputational risks, penalties, and sanctions, which can hinder their revenue and earnings potential. Conversely, companies that proactively address ESG challenges can uncover profitable opportunities, such as those involved in energy-efficient infrastructure or alternative energy solutions.

When ESG risks and opportunities are material, it is imperative for investment managers to incorporate them into their fundamental research processes. This integration can take various forms, including ESG integration and ESG-focused portfolios.

ESG Integration vs. ESG-Focused Portfolios

Investment firms must clarify the differences between these two approaches amidst the confusion created by the proliferation of ESG-related portfolios.

• ESG Integration: This approach incorporates material ESG issues into research, engagement, and security selection within a traditional investment universe. Most of AllianceBernstein’s actively managed investment strategies employ this method.

• ESG-Focused Portfolios: These portfolios define an investment universe based on specific ESG criteria, such as companies transitioning to a low-carbon economy or those aligned with the United Nations Sustainable Development Goals.

Both approaches aim to deliver attractive risk-adjusted returns for clients, but they differ in how they generate those returns.

Navigating Regulatory Complexity

Regulatory efforts are designed to enhance transparency regarding the ESG credentials of investment portfolios. For instance, the EU’s Sustainable Finance Disclosure Regulation (SFDR) categorizes portfolios as Article 8 or Article 9 products, with the former promoting environmental or social characteristics and the latter focusing on sustainable investments. While these classifications help investors identify portfolios that align with their preferences, they also introduce complexity and confusion due to differing interpretations across jurisdictions.

As the regulatory landscape continues to evolve, it is likely that products failing to meet certain expectations will be phased out. Conversely, firms that innovate in researching material ESG issues and deploying capital effectively will likely thrive.

A Case Study: Climate Change Research and Implementation

Climate change stands out as one of the most pressing ESG issues globally, warranting special attention. At AllianceBernstein, climate risk management is a top priority, and we have developed a comprehensive climate transition alignment framework to help our investment teams identify risks and opportunities associated with climate change.

This framework is not a one-size-fits-all solution but rather a tool to understand companies’ unique paths toward a lower-carbon future. Our partnership with the Columbia Climate School enhances our climate research efforts, providing access to academic expertise that informs our analysis of sectors, industries, and companies.

The Value of Engagement

Active investors must engage with company management to develop a nuanced understanding of a company’s risk/reward profile, particularly concerning material ESG issues. In 2023, we conducted 1,703 ESG engagements with 1,296 unique issuers, focusing on developing insights and encouraging action. These engagements not only enhance our understanding of a company’s ESG credentials but also promote responsible business practices that create shareholder value.

Looking Ahead: Shaping the Future of Responsible Investing

The future of responsible investing will be shaped by regulatory scrutiny, fund flows, and performance trends. This evolutionary process will ultimately strengthen the industry. Asset managers that develop advanced tools for assessing material ESG factors will be well-positioned to deliver better outcomes for clients.

While opposition to ESG investing persists, it is crucial that the public debate remains constructive, encouraging responsible investing practitioners to focus on delivering strong risk-adjusted returns for clients. As the industry matures, we anticipate greater consistency and transparency in how ESG factors are integrated into investment portfolios.

In conclusion, responsible investing is not a fleeting trend but a fundamental shift in investment philosophy. By prioritizing materiality and client needs, investment firms can navigate the complexities of the ESG landscape and unlock opportunities for their clients.

Learn more about AB’s approach to responsibility here.

AllianceBernstein (AB) is a leading global investment management firm committed to responsible investing and stewardship. With $669 billion in assets under management as of September 30, 2023, AB integrates ESG factors into most of its actively managed strategies, striving to deliver superior investment outcomes for clients. For more information, visit www.alliancebernstein.com.