10 MIN ARTICLE
At Capital Group, we recognize the need — and value — of integrating material ESG insights into our investment process. This objective is consistent with our longstanding mission to improve people's lives through successful investing.
Our long-term approach, which is a core part of The Capital System™, fits naturally with the time horizons associated with ESG risks and opportunities. Our equity funds' average holding period is over four years — nearly 130% longer than our peers.* Our deep research, regular dialogue with companies and diversity of thought tend to lead us toward companies focused on creating long-term value. We understand that the enduring profitability and growth of a company are directly tied to its relationships with customers, employees, suppliers, regulators and the environment in which it operates.
Given our long-term approach, many elements of ESG are a natural fit with our investment process and are a focus for our analysts and portfolio managers. We have intensified investment in our firm-wide approach to ESG integration, making the process transparent and evolutionary, building in the potential to further adapt it over time as the external stakeholder landscape shifts.
We are dedicating significant resources to ESG
Our integration of ESG builds on our bottom-up, fundamental research and analysis and is centered on three components: investment frameworks, a monitoring process, and engagement and proxy voting. Materiality is not only the foundation of our investment frameworks, but also informs our monitoring process and engagement priorities. Progress in one directly supports the others, creating an ongoing cycle of development. We have been intentional about creating a process that reinforces itself, so we can continuously learn.
ESG integration: Our three-part process
Integrating ESG into The Capital System
The incorporation of material ESG risks and opportunities is deeply woven into The Capital System. ESG is not an "add on" step. Investment decisions are informed by Capital Group’s fundamental, bottom-up research, which includes, where material, analysis of how a company interacts with its community, customers, suppliers and employees. We focus on the ESG issues that directly impact company results and valuations. Our long-term approach, a core part of The Capital System, fits naturally with the time horizons associated with material ESG risks and opportunities, such as climate change and human capital.
More than 200 of our equity and fixed income investment analysts, in partnership with our dedicated ESG specialist team, have created more than 30 ESG investment frameworks that identify the issues we believe to be material to each sector. These frameworks help us understand how material issues affect companies financially and enable us to measure and integrate these metrics into our investment process.
Importantly, in these frameworks, we are seeking to evaluate the risks and opportunities not fully captured by traditional financial metrics. Our frameworks also inform our monitoring process and engagement efforts. These issues include long-term secular trends, such as energy transition and social inequality. We also consider how companies operate and how they are performing compared to sector peers. For example, can they build a competitive advantage by attracting, retaining and promoting the right people? Are they able to increase consumer trust by providing safer products? Are they able to adapt and transition away from carbon-intensive commodities?
Capital Group is not alone in seeking to understand and measure material ESG issues. Companies, too, are acutely focused on managing these topics and reporting meaningful information to investors. In 2020, 92% of S&P 500 companies published a sustainability report. This stands in contrast to the 2011 report, when only 20% did so.‡ The industry is still seeking to standardize sustainability reporting, with a look toward the forthcoming International Sustainability Standards Board (ISSB) to help blend the current patchwork of reporting standards. We believe this work is important and actively participate in the advisory group.
Importance of materiality
We know that the definition of what is material is dynamic. It is not uncommon for an immaterial factor to quickly become material. We view the challenges of determining which issues are material and gauging the time frame over which that materiality will get reflected within share prices as opportunities to which we are particularly well-suited, given our focus on deep, fundamental, primary research.
Human capital amidst a pandemic
As we were in the process of building our investment frameworks, the COVID-19 health crisis and ensuing economic shutdown unfolded, providing a real-life use case. Companies representing nearly every sector were forced to make drastic changes to protect the health and well-being of employees, customers and communities.
Failing to do so carried major business risks. A phenomenon economists’ have now characterized as The Great Resignation resulted in a mass exodus of employees voluntarily leaving their employers. Notably, nearly 628,000 workers left the retail sector in April 2021 alone, according to the Bureau of Labor Statistics, on top of the nearly 800,000 jobs lost in the sector during 2020.§ In the health care industry, job vacancies as a percentage of total openings rose to a record high of 10% in 2021,‖ nearly double the long-term average.
Our research on the importance of human capital has identified some key material issues, including employee health and safety, wages and benefits, supply-chain management and cybersecurity in supporting the rapid transition to digital. Companies with strong cultures, benefits and compensation structures were likely to be more resilient during the pandemic, adapting to new business models and more flexible work environments.
In our analysis, we set out to see how companies were responding to questions like, “How does management attract, develop and retain the right talent?”; “Is there training available for workers to develop skills?”; “Is there a diverse, purpose-driven culture?”; “Are there positive labor relations?” The best approaches to these questions can reduce inequalities, improve the working environment and ultimately prove to be less costly to companies than the risk of attrition.
While the COVID-19 pandemic brought a renewed focus on the importance of human capital development, we believe it has always been a material ESG risk. Notably, 83% of our sector-specific frameworks include human capital as a material issue.
Proprietary research + third-party data:
A powerful combination
ESG data, when based on quantitative or standardized information, can be valuable input to our investment process. Alongside a robust understanding of material ESG issues, we have found that the information used to measure and evaluate companies matters greatly.
With the increased interest in ESG, there has been an influx of ESG ratings and scores. It is important to understand the limits of third-party data. Currently, the discrepancy in ratings across leading ESG data providers is so wide it is nearly impossible to state a singular market view on a company’s ESG profile. A 2022 study by MIT Sloan School of Management found a very low correlation of just 0.61 between top-level ESG ratings from major providers# vs. 0.92 for traditional credit-rating agencies. Overcoming the lack of consistency in ESG scores was cited by investors as the biggest hurdle when incorporating ESG data into investment decisions, according to our latest global ESG study.
The same intention, widely varying conclusions
Sustainalytics Risk Rating and MSCI's ESG score both measure a company's ESG risk exposure and management. Each rating agency has its own way of defining and measuring ESG issues. There are differences in how they choose which issues to evaluate, how they calculate risk and how they attempt to bridge the vast data gaps created when companies report limited or inconsistent information. The result is little consensus across the market and a significant degree of noise.
We need to be selective about the ESG data we use. To inform our ESG evaluation process, our analysts leverage MSCI and Sustainalytics for the monitoring of securities, in addition to other quantifiable indicators using third-party data, which support our investment frameworks in a proprietary in-house tool, Ethos. In some industries, there may be very few valuable third-party data points, requiring a heavy reliance on fundamental, bottom-up, analysis or nontraditional data sources. In other sectors, there are several high-quality indicators that can be readily integrated into our investment analysis.
Our singular purpose is to identify companies that are likely to drive sustainable long-term results. External agencies, while supporting that outcome, each have a different focus that can help explain differences in results. MSCI’s ESG Ratings focus on a company’s operations in the context of its industry and score each company relative to its peers. Sustainalytics focuses on “unmanaged” ESG risks, scoring each company on industry or regional ESG risk exposure minus company actions to manage that risk. ISSB’s mission is different, focused on advancing reporting standards to help companies disclose material, decision-useful information to investors. We evaluate each of these inputs in our process, then rely on our own investment frameworks to establish our view.
Our ESG research in action
The health care services sector is a good example of our holistic, evidence-based approach to ESG. Capital Group investment analysts identified social issues that pose material ESG risks and opportunities within the industry. This meant a focus on consumer safety and product quality, affordability and access, and data security and privacy, all underpinned by strong management quality and accountability.
Zeroing in on material issues
When evaluating the ESG issues within the U.S. health care services sector, Capital Group analysts sought to identify those they believed were most material to the success of the company as a long-term investment.
In U.S. health care services, one key thesis is that value-based care (e.g., incentives aimed at keeping people healthy rather than additional fees for services) is the most sustainable model over the long term. Doctors in value-based care models tend to conduct more proactive patient outreach and emphasize preventive care and ongoing maintenance. We believe this approach helps raise the health of the broader population and, in turn, likely saves costs and increases patient satisfaction and retention.
To evaluate a company against this investment thesis, analysts conduct primary research through dialogue with the company itself. The analysts ask questions directly to companies at all levels of management, not just the executive suite, which helps them understand if the stated priorities are manifested in the company’s culture and operations. Additionally, our analysts don’t ask just once — or even once a year. It’s an ongoing effort.
Beyond dialogue with companies, our analysts look at nontraditional indicators, such as customer satisfaction tracking and net promoter scores. They also stay on top of new regulations and assess the risk of sanctions, including warning letters, fines, restrictions and recalls.
A differentiated ESG view
Our research efforts, as articulated in our sector-specific investment frameworks, will lead us, at times, to disagree with ESG rating agencies. One major ESG rating agency, for example, rates a company we view as a pioneer in value-based care below its peers. The company is penalized for publishing limited information on customer satisfaction rates and not establishing policies on emerging health risks, such as obesity and environmental pollutions. We take a different view — that by changing the incentive structure for doctors, this company encourages preventive care and contributes to overall better health outcomes, which, in our view, is more material to the company’s long-term success as an organization and as an investment.
An evolving process focused on better outcomes
In our fast-moving global economy and society, material ESG issues can change quickly. We constantly review and adapt our frameworks to ensure we are forward-thinking.
We rely on our expertise of engaging companies as partners. In a rapidly changing landscape of ESG and sustainability, we will continue to learn and adapt, to contribute to the improved management of material ESG issues across the board. We remain more convinced than ever that a materiality-based approach to ESG will reinforce the types of sustainable business practices that we believe will drive better results and outcomes for our investors.
* On average, the equity-focused American Funds hold their investments for 4.3 years, whereas their peers hold their investments for 1.9 years, based on the equal-weighted blended averages across each of the 20 equity-focused American Funds' respective Morningstar categories as of December 31, 2022. Fixed income funds are not included in this calculation due to the differing nature of trading in the asset class versus equity investing.
‡ Governance & Accountability Institute, Inc. (G&A) 2021 Sustainability Reporting in Focus report, focusing on the 2020 publication year. 92% of the S&P 500 companies published a sustainability report in 2020 vs. 20% in 2011.
§ U.S. Bureau of Labor Statistics, April 2021.
‖ Deutsche Bank. "Hospital Trends into 4Q and views around 2022."
# Berg, Florian, Kölbel, Julian and Rigobon, Roberto. 2022. "Aggregate Confusion: The Divergence of ESG Ratings." MIT Sloan School Working Paper 5822-19, MIT Sloan School of Management, Cambridge, MA.