Sposored article: Dennis Gepp looks at the role of ESG in the liquidity process.
The consideration of environmental, social and governance (ESG) issues into investment management has evolved with the market’s recognition of how a company’s long-term strategic focus on corporate sustainability can enhance its risk-return profile. Lessons learned from the recent past make focusing on risky corporate structures and ill-focused strategic priorities more important.
It might not be intuitive that ESG externalities can impact the money markets. The focus has been on the equity and bond markets. Adversity may affect credit spreads of bonds and credit default swaps or cause a stock price to tumble.
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Yet, these considerations are essential for money market instruments. Let us not forget how they were changed forever in 2008 when the short-term profit focus of major financial institutions met the rigidity of the bond rating process and overall investor inertia. Many firms did not recognise the imperfection of relying solely on third-party ratings and financial analysis and faced severe consequences.
Immunity
It is crucial to understand that, despite their short-term nature, money market instruments might still be exposed to an adverse ESG situation because the underlying issuer is not immune to these risks.
When an issuer—say, a global bank or a corporation—is hit by an adverse event, all of its securities feel the pinch, be it a bond, a share of stock, repo or commercial paper. More recent corporate scandals, environmental disasters and labor disputes have demonstrated that catastrophes and controversies can adversely affect issuers.
And, of course, the timing of the externality is hardly predictable. An investment manager must be vigilant: The more information, the better.
To be sure, liquidity portfolios only hold specific issues for a relatively short period. Rolling over issuer paper is commonplace and necessary in these highly regulated portfolios. Although a new assessment is applied for each transaction, names on the approved credit list tend to be relatively stable in most market environments.
But investor confidence in the market’s liquidity is essential for stable business operations, so even deep analysis of high-quality issuers, which also takes account of the most material ESG considerations, is required.
We think it is incumbent on investment managers in the liquidity space to incorporate analysis of this arena.
Forefront
Guided by our conviction that responsible investing is the best way to create wealth over the long term, Federated Hermes has been a pioneer in integrating ESG factors into our investment process.
While quantitative metrics form the core of our analysis, these considerations provide qualitative insight into potential risks and opportunities faced by an issuer.
This proprietary research—independent of third-party ratings—presents a variety of relevant information to our portfolio managers and analysts. We gain a more expansive view of the potential risks or opportunities of specific securities.
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Putting a finer point on it, we believe that “engagement” with businesses helps create a clearer picture of an issuer’s ESG resilience. We have direct dialogue with companies, from investor relations to sustainability departments, from the C-suite to boards to assess risks.
We have backed up our conviction by creating a dedicated stewardship team, EOS at Federated Hermes. Staffed by individuals with specific industry experience, they pass on intelligence gained from their interaction to help us make informed investment decisions and advocate for positive change.
We believe that today more than ever, money market funds and similar vehicles must utilise an enhanced investment process that, in addition to credit fundamentals, focuses on the long-term strategic direction of its issuers to uncover risks that could result in a surprise downgrade. Incorporating ESG elements to this process adds considerable heft.
Dennis Gepp is senior vice president, managing director & chief investment officer at Federated Hermes.
Photo by Matthew Smith on Unsplash
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