ESG: Virtue or Vice?
Wrong Question.
ESG is “just” a value-add, and we should expect more from it.
One might say it was only a matter of time.
The “mainstreaming” of sustainable investing has been the story of the decade in investment management. Inevitably, success has invited varying degrees of backlash in the form of whistle-blowing, regulatory investigations, boycotting, and more.
Some of it was frankly overdue. Let’s face it, the world of sustainable investing is home to a mix of trillions of newly committed dollars, ill-defined processes at some firms, and a set of clients and investment professionals with powerful, “extra-financial” motivation to literally save the world. This potent combination has produced a wide range of outcomes for investors; skepticism and scrutiny are entirely appropriate. Notably, higher levels of scrutiny from regulators have already ratcheted up expectations for funds and managers that wish to assert their environmental, social, and governance or “ESG” research credentials. We see this as a positive early outcome.
A naming-and-shaming approach may be effective for a small list of big offenders, but we should all be more demanding of our investment managers and advisors. ESG, like any investment approach, can be practiced well or haphazardly. We should learn from the approaches that have consistently generated returns and delighted clients for long periods of time. By examining the big objections to sustainable investing–process weakness, political bias, and misplaced purpose–we can see how some of the industry’s best practices are poised to overcome those objections, and raise the bar on what we can all expect from our investments.
Process... is about people.
One of the problems often raised about sustainable investing is that “it” lacks consistency. Firms in this space employ wildly diverging practices. Some screen out the bad actors, others invest in themes such as clean technology, others seek to connect investment dollars to real-world impact, and still others–one would hope most–aim to generate attractive returns using ESG insights.
In some businesses, following strict rules, patterns, and blueprints is essential–it’s best not to be individualistic and creative when effecting a hazardous materials remediation at a biolab facility, or when building an airplane. This is not the case in investing. The most successful sustainable investing strategies were built over the years by committed, diligent managers–people, to be crystal clear–who used their own thinking and discretion to interpret diverse datasets and make informed decisions. While each of these managers may have their own disciplined investment process, we believe imitating each other is not a prerequisite for success. Similarly, we do not look to “growth” or “quality” or “quant” investors and expect them to match each other’s playbooks.
Larger asset managers have been able to build fairly passive approaches to ESG integration, where indexes or portfolios with low active share are “tilted” to emphasize holdings with lower reported carbon emissions or other desired ESG metrics. This fits with the broader trend in the fund industry to build products based on “classic” factors of value, quality, size, style, and so on. Our team seeks to build more concentrated portfolios from a small set of our very best ideas–and we think both styles (and others) can serve clients well. But even passive factor-based strategies cannot create value without skilled, sophisticated investors at the helm that can implement, test, and adjust those strategies over time. Layering in ESG as a consideration requires similar expertise and sophistication.
More to the point, we believe investing is about skill and it’s about people. ESG information is not a panacea; it is just information, and we still need smart people to use that information alongside other datasets to make good investment decisions. Variability in quality and integrity among ESG investors is no different from what we see in the “mainstream” investing space.
Clients who seek investment managers with ESG expertise should expect a clear understanding of where the managers find relevant extra-financial information, how they discern both qualitative and quantitative ESG data into investment insights, and transparency on how they apply these insights in a consistent way.
Politics: The ultimate distractor
When socially responsible investing, or “SRI,” was thought of as a new approach, the primary tool used by managers was simple screening: SRI managers would not invest in certain companies or business practices that clashed with a subjective notion of social responsibility. Often this led to entire industries–alcohol, tobacco, etc.–being excluded from portfolios.
Today, investors generally use far more nuanced approaches, yet a growing list of opponents are not interested in that nuance. There has been a particular focus in the past year or so on funds that are not invested in oil and gas companies, based on the idea that ESG investing is just a means to deliver an ideological agenda.
To be fair, banning large sectors of the economy from a portfolio does not, in our view, embody thoughtful investing. However, a blindly screened index fund is a very different animal than a portfolio of carefully selected companies that a manager views as long-term winners. Imagine an investment manager who seeks to avoid geopolitical and regulatory risks, leveraged situations due to high capital intensity, and companies that are highly sensitive to commodity prices, economic cycles, or changing consumer preferences. Sounds reasonable, right? Well, that is the thinking that leads many managers to look for investments outside the oil and gas industry. They may be right or wrong, but their assessments are based in investment logic, not emotion.
Of course, it is appropriate for capital owners to ensure that investment firms are using investment logic to make decisions about oil companies, but it is equally appropriate to question those who are attacking the very concept of sustainable investing as political ideology. If done well, using additional (extra-financial) information in an investment analysis is likely to be more about a manager’s diligence rather than doctrine.
Purpose is powerful.
Most practitioners of sustainable investing are driven by at least two powerful incentives: to gain a performance edge, and to direct capital in ways that can lead to a positive real-world impact. The search for an ESG-driven performance edge is in some ways a search for securities that can thrive over the long term amidst volatility and uncertainty. In just the past few years, we have faced political and economic shocks, a pandemic, powerful social justice upheavals, war, and intensifying urgency to address climate risk. We simply cannot effectively manage these ESG risks without understanding them. Further, we believe that some of the most exciting business models in today’s market are those that are helping to solve some of our thorniest sustainability challenges.
Generating positive impact is an ambition shared by many investment firms and many clients. But that desire has been criticized for running afoul of the concept of fiduciary duty–in simplified terms, the duty to act in a client’s best interests at all times.
These critics resist the idea of considering extra financial information to make purely financial decisions, but we would argue that sustainable investing and fiduciary duty go hand in hand. One notion of “sustainable” in finance refers to concepts such as durable growth, persistent cash flows, and investing on the premise of getting paid to buy and own great companies. Another refers to investments or assets that “meet the needs of the present without compromising the ability for future generations to meet their own needs.” 1 Isn’t this a fiduciary’s responsibility, over the long term, to its pension beneficiaries?
Insofar as businesses and hence investment returns depend on natural resources, a stable climate and stable societies, the long-term sustainability of these elements should be a key consideration in capital allocation. In short, all of capital allocation has an impact. Investors have good reason to understand if their holdings are more likely to build that sustainable future or directly undo it.
People, plus process, plus purpose, minus politics. A seemingly simple formula for success, and we should expect that good investment managers and advisors will practice that formula without being distracted from it. But the challenge we all face as investors is the same one we’ve faced since the Amsterdam Bourse opened in the 1600s–separating the signals from the noise–and the sustainable investing universe has grown exceedingly noisy in recent years.
Our solution to this dilemma is not especially innovative. It’s just a simple resolution to do the boring, roll-up-your-sleeves hard work. Investing is a process of continuous improvement, and there are no shortcuts or marketing materials or whiz-bang algorithms that can replace the diligence and discipline to tune out distractions and focus on what really matters. Do I think this stock or this bond is a good investment? Is my investment manager providing enough transparency, consistency, and results to give me confidence they can help me achieve my goals? Do my portfolio holdings embody the “built-to-last” traits I want for my long-term investment horizon? If we focus on “signal” questions such as these, we are more likely to benefit from investment results that serve clients and society well. 
11987, the United Nations Brundtland Commission definition of sustainable development.