Dynamic materiality

The notion of materiality is a well-established concept in sustainable and responsible investments. It follows an approach similar to financial materiality in financial corporate reporting that defines financial materiality as a scope of information that a prudent investor might be interested in to make financial decisions.
Materiality of ESG factors is similarly constructed as information that is important to make sustainable and responsible investments. Some industry bodies have made a herculean work to create a system of materiality factors on industry level. Notably SASB created hierarchical classification of the financially material issues for 11 sectors and 77 industries.

Nevertheless, companies even within the same industry may significantly vary in internal production processes, products, market positioning and physical presents. The essence of hierarchical classification framework creates limitations to identify these particularities. Oven more, stakeholders’ and shareholders’ perspectives may differ significantly on what is or will be material. One important difference is between value-oriented investors (interested mainly in financial materiality to achieve superior financial performance) and values-oriented investors, interested in environmental and social materiality.

Taking a wider look, stakeholders have distinctively different views on materiality of issues depending on time horizon of investments, geographic basis, asset class specifics and perception of boundary of the firm (e.g., how far down supply chain).

There is a concept that has become popular recently, declaring that advances on communication technologies and the internet enabled multiple stakeholder groups to congregate and participate in global one-to-many and many-to-many discussions in social media and other channels around brands, products, supply chain and labour market corporate behaviours. The popularity and extremely low barrier to actively engage in these discussions created an environment when definition of what is material for both financial performance and ESG impact is slipping from hands of corporate bosses and handful of experts into chat rooms at social platforms.

Without particular link to ESG issues, the effect of social media communications onto financial performance of investments in its extreme may be observed in recent story of GameStop stock, where prices were elevated short-term by claims of greed, dishonesty and bias in governance of financial markets.

To grasp these changes and new-found complexity, researchers proposed to separate slow-moving factors of “core-materiality” and fast-moving factors of dynamic materiality. The core materiality is defined as a stable consensus of what is material for a given industry remaining relevant in decades. In contrast dynamic materiality is a concept that grasps the flowing nature of some issues’ importance within a short-term time horizon as well as shifts in investors and stakeholders’ perspectives.

These concepts can be effectively applied in investment practice to make more efficient investment decisions. For initial design of investment strategies, we shall use long-term or core materiality to accompany initial assets selection and screening. Risk parameters and portfolio composition weights later may get influence from the short-term or dynamic materiality assessment block within given limits.[1]

Growing popularity of thematic investment strategies, impact investment approach and sustainable finance in general make these developments quite popular. As recent story with GameStop “stonks” have demonstrated, we shall expect similar volatile developments based on social of environmental controversies in the nearest future. It’s time to get prepared now.

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Dr. Tymur Khusainov
Sustainable Finance and ESG Consultant