What You Need to Know
- International small-cap active managers have higher hurdles when adding ESG overlays.
- Just like country or sector exposure, ESG is a risk factor.
- Despite the hurdles, the rate of ESG adoption by international small-cap companies will increase, assuming growth in ESG evaluation continues.
It seems all but guaranteed that the focus on environmental, social and governance investing will endure after a turbulent 2020.
While reliable ESG data is available for U.S. and European large caps, the quality of information can vary widely at a company level and be nonexistent outside those regions. Therefore, significant additional effort by active quantitative and fundamental managers is required to assess ESG metrics in the international small cap arena.
Moreover, leading ESG ratings agencies can’t be expected to cover the entire investable universe. As an example, third-party providers cover less than 40% of our fundamental international small cap portfolio holdings with a market value of less than $2.5 billion.
That shifts the onus onto active managers to uncover relevant data points. For our fundamental international small cap strategy, this can take many forms including meetings with company executives, regulators and unions, in addition to site visits, employee surveys, and legal research. The need to overcome barriers such as geography, language and culture adds a further layer of complexity for those operating in the international small cap space.
Whether a manager takes a quantitative, top-down view or a fundamental, bottom-up approach, they need to work harder and smarter in this asset class to ensure investment decisions account for the risk that unsustainable business practices pose.
Just like country or sector exposure, ESG is a risk factor. It is material to a company’s prospects and responsible quantitative and fundamental managers in the international small cap space should commit to investing in companies with verifiable ESG practices.
While often difficult, such work can help to accelerate ESG adoption by companies. On one of our research trips to South Korea, a CEO had no response when we asked about executive team diversity. Several quarters later, the investor relations representative emailed us a copy of the company’s first attempt at an ESG mission statement, including actionable goals.
We believe the rate of adoption of ESG by international small cap companies will increase, assuming the explosive growth in ESG evaluation continues. At the end of 2020, 392 open-end mutual funds and exchange-traded funds in the U.S. claimed to have an ESG focus, a 30% increase over the prior year and a tenfold surge in a decade, according to Morningstar.