Third Party Ratings: A Starting Point

Chris Hogbin: Interest in ESG integration and responsible investing is growing rapidly in the investment community. At the same time, we’ve seen the usage of third-party ESG ratings grow, too. At AB, we use third-party ratings, but only as a starting point for our fundamental research.

How are these ratings useful? They help identify existing material ESG issues and what the market may be thinking about. At AB, we pay for access to these ratings just as we subscribe to sell-side research or access to consensus estimates. But there are limitations to third-party ESG ratings. That’s why we use them very differently than passive portfolio managers, who use third-party ratings as the basis for building low-cost ESG exchange-traded funds.

Our proprietary research and industry insights are the source of alpha in our investment process—we don’t outsource that research. Because ESG is fundamental to investing, we don’t outsource our ESG views to third-party providers, either. Our proprietary ESG views are a key driver of risk-adjusted returns, so we spend a lot of time developing them in collaboration with experts from AB’s Responsibility team.

Ryan Oden: Sharing our ESG views firmwide is critical, too, and that’s where ESIGHT comes in. AB’s cross-asset-class research and engagement tool is a hub for all of our proprietary ESG assessments. [show slide 1] ESIGHT also houses MSCI and Sustainalytics ratings, but they’re only a starting point. The real research power comes from the ESG assessments and engagement insights from AB’s investment teams. Sharing our findings across investment teams amplifies the power of our proprietary ESG insights.

Chris Hogbin: ESIGHT allows our investment teams, whether they sit in equities or fixed income, to instantly access insights from the most recent assessments and engagements conducted by AB’s investment teams. We can integrate these insights into our investment processes, which we believe enables us to deliver the better outcomes our clients expect.

Michelle Dunstan: Integrating ESG involves an enormous effort that goes well beyond what third-party ratings can provide.

Third-party ratings are backward-looking. Analysts wouldn’t look at last year’s earnings to make decisions. You have to understand how earnings and cash flows are evolving, how fast revenue and margins are growing, the future risks to a company. That’s true for ESG factors, too. Understanding a firm’s strategies, actions and future direction requires active research and engagement.

Third-party research often relies on web-scraping tools alone or is limited to company disclosures. So, they’re based on what a company says, not what it does. Analysts must understand what‘s actually going on at a company—and where it will be in one year, three years, five years.

Also, third-party research agencies distill their analysis into a single letter grade or rating, even though ESG risks are diverse. A company that scores very low on environmental issues may have an amazing social score. If the “E” and “S” combine to a neutral score, it obscures the underlying reality. Our analysts need to understand the nuances in ESG risks one-by-one.