The coronavirus outbreak has diverted attention away from the drive towards ESG-focused investing that had become the dominant narrative in the asset management industry.  Yet whilst its prominence may have temporarily dimmed; it will almost certainly be one of the defining issues for investors over the next decade.

Although I am supportive of the determination to make ESG factors critical to investment decision making; I worry that professional investors have become focused on the outcome (achieving some form of ESG badge) rather than the process required to get there.  Asset managers frequently proclaim that ESG is ‘in their DNA’ whilst keeping a straight face and fail to acknowledge that it is one of the only routes they have to maintain high margin active management business (alongside private markets).  Every investment process now ‘integrates’ ESG because they have to, even if it is unclear what influence these factors really have.  In many cases ESG has become a tick box or a label. This is a disservice to the complexity of the subject and what the core principles of ESG investing are designed to achieve.

 Whilst the issues to consider are myriad, below are some of the most important questions around ESG investment philosophy that need to be considered by all involved:

Are you willing to sacrifice investment returns? Although it is wonderful to work on the assumption that you can ‘do good’ and improve your financial returns this should not be the founding principle of any ESG-focused investment.  When applying portfolio restrictions that constrain choice you must be reducing your ex-ante return expectations – otherwise they would not be a constraint (of course it might turn out that they improved returns after the event).  Whilst ESG investment is about far more than limits and restrictions; even if we move towards ‘Sustainable’ and ‘Impact’ strategies there is not an insignificant probability that investing in a manner that has material environmental and societal benefits may diminish your investment return.

Every investor in this area needs to ask how they would feel if their investment strategy underperformed a broad market benchmark for a sustained period.  At its core making a decision to invest with an ESG mindset should be based on the notion that you care about more than simple financial results and understand the possible consequences of that from a return perspective.  Three years of underperformance from ESG factors should not lead you to recant your beliefs.  Part of accepting a broader definition of what ‘returns’ means is being able to understand the positive non-investment outcomes that your portfolio might deliver. 

Do any ESG elements constitute a risk premia? It is possible, but there is nowhere near sufficient evidence to prove it.  The strongest case to be made is that within the governance component there are elements that are intertwined with the quality factor, which can be considered a risk premia.  Broadly, however, it would seem a stretch to assume that ESG factors deliver excess return for their level of risk, and provide some form of external societal and environmental benefit in addition.  Of course, in specific cases this might be true, but it is unlikely to be broadly applicable.  Furthermore, as ESG factors become an increasingly vital element of investment decision making it is likely that investors will be willing to hold certain securities at higher valuations, and therefore with lower expected investment returns.

Should ESG assessments be absolute or relative? It is important to understand the heterogeneous nature of ESG scoring and assessment.  One of the most critical is the distinction between absolute and relative.  Are you comfortable investing in companies that are the best in their industry, even if the industry is poor in certain ESG aspects – the best airline, for example?  Or do you think about ESG in absolute terms – how strong is a potential company on ESG factors relative to everything else?  The latter option offers a level of ‘purity’ to an ESG philosophy but brings with it a cost in terms of a lack of diversification.

Should you worry about where a company is now, or where it is going? Another crucial consideration is around what could be referred to as ESG momentum.  Should you focus on companies that rate highly from an ESG perspective now; or also incorporate those companies that may fare poorly at present, but are showing signs of positive change?  If a key aim of ESG investing is to bring about a broader shift in corporate behaviour, then giving some reward to positive change seems prudent.

Should you divest or engage?  This requires careful thought. Of course, there are certain companies that you may wish to avoid from a pure values perspective – controversial weapons, for example – but is it always best to relinquish investments that are deeply questionable from an ESG perspective, and what do you achieve by doing so?  My initial thinking on this was that divestment could be an effective means of bringing about change, primarily on the basis that if carried out in significant magnitude it could materially increase the cost of capital to that business.  However, as Izabella Kaminska at FT Alphaville eloquently argued[i]by divesting you lose all influence and any chance of bringing about material change.  Furthermore, you allow other investors (perhaps those with purely financial motives) to invest with more attractive return prospects, and tacitly permit the company to continue absent any shareholder pressure to alter its activities.  The question therefore should not simply be to divest or not, but if I remain invested what influence can I exert (alongside others) and how might this change the business.?  Also, if I don’t invest, who does?  The problem with this last question is that it provides a get out of jail free card, which allows anyone to own anything.  Therefore it is crucial that you are able to justify and evidence your ability to influence a company. 

Is active or passive the best approach?  Although a perennial favourite for ESG deliberations, it is a false dichotomy.  The real question is about whether a rules-based decision making approach (such as an ESG index) is sufficient or do you require additional qualitative judgement to run an ESG oriented strategy?  Even this distinction is limited by the fact that ESG indices will involve qualitative assessments both in the construction of the benchmark and the underlying scores that inform it.  Unlike in broad asset class decisions a simple active versus passive choice doesn’t exist; it depends on your objectives and requirements.

Are the multiple ratings services a problem? We are likely all well-versed in the fact that the major firms in ESG ratings adopt significantly different approaches in their company assessments resulting in a worryingly low correlation between scores from different providers.  The same portfolio could have positive or negative ESG characteristics depending on the lens through which you choose to analyse them. The problems with this lack of consistency are often highlighted as a profound weakness of ESG investing; but we should also consider an alternative scenario where one firm held the ability to define what represented ‘good’ from an ESG ratings perspective.  The idea of being beholden to a single judge in this regard is equally unappealing. There is at least some benefit to the diversity of thought embedded in numerous ESG ratings services, and there is far more subjectivity in defining ESG quality than credit quality, for example, so this divergence is likely a feature rather than a bug.  Clearly it is important for investors to understand the different methodologies and assumptions, and also use their own.

The other issue with ESG ratings is the spectre of Goodhart’s law – when a measure becomes a target it ceases to be a good measure.  Whilst ESG scoring will likely encourage companies to improve and potentially lower their cost of capital there will inevitably be gaming.  Firms will look at what is being measured and almost certainly target specific areas to improve their ratings.  Although companies seeking to increase their ESG score is a positive; a close eye will need to be kept on loopholes in the ratings, and situations where optics supersede substance.  One indirect benefit of the aforementioned issue of multiple scoring approaches is that it reduces the ability to game or target specific metrics – because of the very inconsistency.  

Is ESG investing in a bubble? An investment bubble needs a compelling narrative, widespread participation and a complete disregard for valuation. ESG has momentum and a compelling story, but not the broad and complete disregard for valuation and future returns.  The danger for ESG investing is that because it is about more than financial returns there can be a tendency to make valuation subordinate to other issues.  Furthermore, flows into ESG can create a self-reinforcing problem, where strong appetite for positive ESG stocks encourages more investors to convert because past performance is appealing.

The fact, however, that ESG is such a nebulous term and the ratings highly subjective means that a widespread bubble is unlikely and actually very difficult to define – what would a bubble in ESG look like?  More possible is that there will be certain areas of the market captured in the drive towards ESG that will (and have already) moved to unsustainably lofty valuation levels.  The other potential ramification is an increasing valuation gap between positive ESG stocks and those that are uniformly excluded or commonly score poorly.  I did think for a time that things could not get much worse for value investing, but the move to ESG is another potential headwind*.

How do you balance principles and diversification? Your ESG philosophy will have a significant bearing on the level of diversification you are able to achieve in your portfolio, and it is important to be clear about the sacrifices you are willing to make.  For example, in a multi-asset fund are you willing to own sovereign bonds?  In an equity fund are you comfortable excluding swathes of the market and being narrowly exposed to certain styles, sectors and industries?  There are trade-offs to be made and you need to be acutely aware of the investment implications of these.

What matters and how much does it matter? Implicit in any ESG score or rating will be assumptions about what issues are important and how important they are.  An overall ESG score will incorporate a hugely disparate group of factors, from carbon intensity to board level gender diversity, which are almost impossible to compare in any reasonable fashion.  Furthermore, judgements are being made about the relative importance (or weighting) of each factor at an E, S and G level, and also regarding the underlying metrics that fuel the headline scores. 

The use of the ESG definition as a coverall term for such a diverse group of factors and issues is almost certainly a net positive as it brings focus and direction to a movement that could otherwise be unwieldy and disparate.  It also offers welcome simplicity to a horribly complex and subjective area that could leave many afflicted by decision paralysis.  Those benefits notwithstanding, we should be aware of the implicit assumptions and judgements we might be making. 

It is easy to be cynical and critical about aspects of the growth in ESG investing and the motives of some involved in it.  Yet whilst it should be held up to scrutiny, there is also the possibility that we allow perfect to become the enemy of the good.  For all of its faults and limitations the move towards ESG influenced investment decision making in recent years is very likely to be of long-term benefit to us all.  For it to continue to evolve and improve it is important that we are realistic about the investment implications of any ESG approaches we adopt, and ensure that we are willing to understand what underlies simple definitions, scores and labels.

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* Or opportunity, depending on your time horizon.

[i] https://ftalphaville.ft.com/2020/02/19/1582111795000/Climate-activists-would-be-better-off-buying-BP/