Environmental, social, and governance (ESG) investing has reached an inflection point. A substantial proportion of institutional assets are now invested under some sort of ESG mandate (33% in 2020, according to U.S. SIF).
A natural concern with ESG going mainstream is whether or not it will be diluted by the many new entrants throwing their hats in the ring. One of the most-discussed ESG topics in the media over the past year has been the threat of “greenwashing,” and a variety of regulatory frameworks are emerging to set a minimum or “floor” expectation for investment offerings that are labeled as “ESG,” “impact,” or “sustainable.”
We recently had the opportunity to moderate a panel at Confluence Philanthropy’s 11th Annual Practitioners Gathering that addressed the challenge of establishing an authentic and inclusive approach to ESG that still had accountability. As follow-up, we wanted to share a few thoughts on how asset owners can seek to raise the ESG bar.
Focus on managers who view ESG factors as material investment risks and opportunities:
ESG adoption has accelerated greatly in the past decade—largely because the link between ESG risks and investment risks has been made more obvious (think: climate change, COVID-19, and injustice). Investors around the world have constructed strategies across varying asset classes, market caps, and styles that allocate capital to issuers that are rewarded by the market for helping to solve for these environmental and social challenges. As such, many ESG strategies have matched or beaten their broad-market benchmarks over meaningful periods of time. Institutional investors can assemble a multiasset portfolio populated solely by ESG-oriented managers with strong track records.
But in a booming industry responsible for trillions of dollars in client assets, not all investment options will be created equal. Just like not all traditional investments can promise performance despite their best efforts, not all ESG vehicles will, either. Similarly, while all investments have an impact, labeling a strategy as “ESG” is not a guarantee that the impact will be positive in nature (especially given the subjective nature of the impact itself). By focusing on asset managers who view ESG factors as material to investment fundamentals, not peripheral, we believe asset owners can find investment solutions that create more meaningful financial and social impact.
While we believe performance should drive selection of managers to fulfill primary equity and fixed-income allocations, we also think that certain investors can and should consider investments that prioritize social impact over financial impact or returns. Such investments can be evaluated under different criteria than a “core” portfolio holding, but they can be a powerful way for organizations to generate program- or mission-related impact while still retaining their principal.
ESG is not a magic formula; it requires expertise to implement:
Many ESG practitioners attempt a formulaic investment approach—they may exclusively depend on third-party ESG ratings, or screen out entire sectors of the economy to create a “floor” for what they will hold in their portfolios. This simplification is certainly appealing and perhaps easy to explain to prospective investors.
Unfortunately, in our experience, much nuance is lost when using these simplistic approaches to ESG. For example, there is widespread dispersion among ESG research companies that rate issuers; one ratings system may view a company positively, while another gives the same company a “thumbs down.” These research firms are not “right” or “wrong,” they are simply using different criteria to judge investments. More importantly, looking at an ESG “score” in isolation does not provide meaningful insight into the worthiness of an investment.
As active managers, we don’t think there is a substitute for thoughtful investment decisions made by experienced investment professionals. We believe portfolio managers should be committed, well versed, and passionate about fundamentals, and similarly, ESG managers should be well versed and seasoned in evaluating ESG risks and opportunities on a case-by-case basis. We believe that one way to understand the authenticity of a firm’s ESG efforts is to understand the ESG expertise behind the professionals making capital allocation decisions.
In short, be wary of managers who propose a simple, formulaic approach to ESG investing. If it sounds too good to be true, it usually is.
Speak up loudly where it counts. Asset owners can do more than “raise the floor”—they can also “raise the ceiling” for what they expect from investment managers and advisors.
Climate change and diversity, equity, and inclusion (DE&I) are two issue areas where asset owners and investment managers have collaborated extensively to raise the ESG ceiling. The intensity of investor focus on these topics—not just with the companies themselves, but with leading index fund providers that own major percentages of most public companies—has contributed to a more rapid pace of change in terms of corporate policies on diversity and justice, more robust climate commitments, and a surge in green, social, and sustainability bonds that fund impactful projects, and sustainability-linked debt whose coupon rates are linked to measurable environmental and social progress indicators.
The hard truth is that the investment industry is broadly resistant to change. But if anything motivates an investment firm, it is hearing from many clients and prospects that change is needed. We are grateful for the advocacy from Confluence members who continue speaking loudly about what they expect and need from their investment advisors on issues like DE&I, climate change, and other critical priorities.
- Katherine Kroll, Senior Sustainable Investing Specialist, Brown Advisory
