A Critique of Pure Frenzy
As the ESG investment movement gathers momentum, it seems as though the need for critical appraisal of the activity is being pushed to the corners of our attention. All of the major asset managers and banking institutions have jumped on the band wagon to provide some product or service, designed to capture the enlightened customer who, in keeping with the buzzwords of the times, wants some exposure to socially responsible investments.
This might lead us to think that the world is headed for better and brighter times in which concerns over environmental, social and governance issues ensure that companies, economies and the human race are converging towards a fairer, egalitarian and just utopia.
The reality, as measured by rising inequality and continued questionable practices in many industries (the rare metals and palm oil industries come to mind) gives pause for thought. The fact that the mainstream banks and asset management companies that were initially making money by offering financing and investment to the offending parties, are now going to earn even more money by embracing a “theme” — labeled sustainable, ethical and socially responsible, is cause for concern. It suggests that the kind of ESG investing that the mainstream is embarking upon is not what is required to address the issues as expressed in the 17 Sustainable Development Goals(SDGs) of the United Nations.
Even the SDGs of the United Nations present some undeniable challenges. Developing countries need to use more energy and resources in order to improve their living standards which, on a planet with finite resources, is likely to present some problems. The continued infatuation of developed economies with economic growth, again within those same finite planetary resources, exacerbates the problems further. Projections for the amount of spend needed to enact the systemic changes for the planet’s climate to remain below tolerable increases in global warming are still far short of what is needed.
Something in all this celebratory progression of ESG investing has tripped my intellectual alarm bells. I see a pattern that reminds me of the organic food craze that — as a multi-billion-dollar industry — is still growing. Once upon a time, food was food. Nobody seemed to care how a carrot or lettuce was produced because we all knew that nature was to blame. With the arrival of supermarkets and mass food production aided by the agricultural, chemical, bio and genetic engineering industries, we are today all too aware that, how the carrot or lettuce in our plates came to be, can make a world of difference in terms of health and well-being. Essentially, our naturally produced carrot and lettuce has been relegated to a category of expensive and exclusive foodstuffs, for which the chain of production now charges a multiple of what we used to pay for the original natural produce. A similar alienation of the solution from the root of the problem is occurring in ESG investing.
We are being alienated from an idea that we took for granted: “Well-run” companies produce better financial results than “poorly run” companies. Today, we have to pay extra for non-financial ESG data so that we can evaluate whether the profits of a company in which we have invested are not ill-gotten gains or ethically tainted. For the deniers of ESG investing, we shouldn’t care how the profits were achieved; we should leave the policing of companies to the (unhampered) free-market, (permissive) corporate law and (dwindling) government regulation to focus on the traditional financial indicators which we hope will allow us to predict the highest future stock prices of our investments.
Corporations are not designed to have a conscience and what they have been designed to do — namely maximize shareholder value — is exactly what they do; with all the collateral damage that their pursuit entails. Their objective, as currently defined, prevents them from changing the system in which they operate. Change would require that they become critical of the concepts that drive them. It would be suicidal for a corporation to ponder or resist the structure of the system in which they operate as any exchange-listed company CEO can attest. Corporations will only seek to pursue their objective within the constraints that society places upon them, and there aren’t too many constraints other than to be profitable (“legal” is questionable and depends on size) — is what we are discovering through the increased transparency made possible by the Internet and other initiatives for disclosure. Corporations can get away with murder; witness the lack of any jailed bankers after the revelations by the US Department of Justice about HSBC Bank USA and HSBC Holdings Plc’s role in laundering money for murderous drug cartels from 2006–2012 despite full admission of wrong-doing. This is just one example, of which there are many, but I won’t bore you with a list.
The depth of application of ESG criteria, purely from a risk perspective, could never go far enough. In as much as information is available to predict or foresee any corporate activity that might cause consternation by the public at large, violate government regulations or industry standards, it would seem logical and prudent that any potentially stock-price-tanking transgression should be identified and monitored. To make things worse, there are fuzzy lines where the social responsibility of one company ends and that of another begins. Economies are integrated wholes, with suppliers and clients switching roles depending on which part of the production or distribution chain you choose to observe. Apple sourcing rare metals for their smartphones from Glencore might be an example.
For professional investment managers, ignoring the non-financial factors of corporate activity would appear to be a luxury they could hardly afford. A professional investment manager is paid to structure and manage assets for her clients in a way that minimizes risk and maximizes potential returns in addition to a lot of other criteria. One would think that in order to achieve this, an investment advisor would take as much data into consideration as possible to avoid the assets of her clients suffering from adverse activity or information that might adversely affect the value of investments.
Enter the Investment Fund
Collective investment vehicles have become so widespread and synonymous with investing that many investors have forgotten how investments were structured prior to their ubiquity. Back in the day, a portfolio was a collection of single-line securities that were placed into a client’s account and managed in relation to the circumstances, objectives and needs of each specific client. The idea of pooling investments into a structure that investors can buy into, is not new and makes sense if the objectives of the client and those of the investment fund are aligned. After all, investment funds allow for specialization — the manager professes to know about the strategy her fund is promoting — and performance tracking, either in relation to a benchmark (markets, sectors, other indices) or in absolute terms, in which the amount of money at the end of a period is compared with the amount at the beginning.
Efficiency, liquidity and specialization are convincing arguments that support the explosion in the number of investment funds in the financial investment landscape. It is said that there are more investment funds today than there are securities in which they invest. From the investment manager’s perspective, however, efficiency, liquidity and specialization taken for granted, the profit motive comes to the foreground. By pooling investments into a single purchase by the investor, the investment manager can distribute the same investment strategy an infinite number of times across all client portfolios. What’s not to like? Well, for one thing, this means that the client or her portfolio manager no longer has a say in the decision-making over the securities within the fund, only whether to buy, hold or sell the fund itself.
I’m not trying to get harsh about funds. I’m all for the increased attribution of assets to ESG funds, but I get the strong feeling that the fund solution to ESG investing presents a hypocrisy or an oxymoron for some of the ESG-labeled funds and their promoters. There are exceptions, most notably the firms that were built on ESG investment specialization. The widespread adoption of ESG as a money-making theme to be included in a broad selection of both non-ESG and ESG products alike, seems opportunistic, hypocritical and insincere. The oxymoron is the placement of a big traditional firm name that has been fueling the traditional carbon economy next to ESG.
What does it actually mean to invest in a socially responsible manner? Taking a cue from the acronym “ESG” in which environmental, social and governance factors are integrated into the investment process, it is necessary to then define what each of these three concepts mean and how they translate into the activity of evaluating and investing in companies. The three terms refer to the sustainability and ethical impact of a company. Environmental has become almost synonymous with climate change and the effects thereof, focusing on the activities of a company with regard to its impact on natural resources. Social has come to refer to the impact of the company on the social fabric in which it operates. Governance generally refers to the aspects of corporate activity to stem or fight corruption, human-rights violations and lack of diversity. From these definitions, it should become obvious that depending on how far the interpretation is taken with regards to whether or not to invest in specific securities, the scope of examination and the consequences for evaluation and investment can have very different outcomes and many of these decisions cannot be delegated to a fund manager or they risk becoming meaningless.
The most important factor to integrate into ESG investing therefore is systemic change. This has caused some to propose that next generation ESG investing should be ESGS — the “S” at the end to refer to the systemic requirement for the former three letters to have any sustainable impact. Achieving systemic change is complicated. Most agree that it can only be gradual and that it will most likely come from concerned citizens rather than institutions, public or private, because the final say on what we want our economies to achieve is defined by democratic societies through votes, investment and consumer habits.
Tick the Box or Make a Difference
In many of the most popular ESG investment vehicles (best performing, largest by assets), the top holdings are securities of companies that have good track records on some ESG issues; not so good on others. Many of these companies are probably what non-ESG funds would invest in because traditional financial analysis (which shouldn’t be neglected, by the way) recommends those same securities. The differences with mainstream funds start to appear in the smaller holdings of ESG funds, where they have less of an impact on the tracking error relative to the benchmarks against which the fund managers are trying to compare or compete.
What does this mean for the end client? One of the consequences can be over-concentration of large corporations in the portfolio. If the non-ESG funds and the ESG funds alike hold the same securities, then by having the two funds in the same portfolio, the client might end up with too much of the same security than is good for diversification. Another consequence is that, although a client would hardly disagree with the well-intended blurb that describes the objective of the fund, the very decisions and activity that make socially responsible investing just that — socially responsible, are delegated to a fund manager that has her own agenda — which may or may not coincide with the ethical objectives of the client.
The risks to which clients are exposing themselves from an ESG perspective are vague and the trade-offs between returns and alignment with their values and convictions are often not measurable or actionable. Investors seem satisfied with basic criteria such as past performance and reputation of the investment manager for evaluating ESG investment funds without really knowing the deeper strategy of the investment manager and her alignment with their own ethical perspective.
The Commoditization of Ethics
Values and convictions like ethics in general are personal. How can you create a pool of money and convince investors that you have their ethical and moral strategy all figured out? The “one-size-fits-all” mentality in an area where multiple factors are key in achieving a meaningful and effective result is puzzling. If socially responsible investing is about a process of knowing the companies in which you invest down to their intentions, values, mission and ethos, how can you delegate the investment process to someone that you have never explicitly asked to define their position on a variety of non-financial subjects? The investment fund industry is colossal and has duped everyone into the idea that the way to invest is to buy an investment fund or, even cheaper, an Exchange Traded Fund (ETF).
The great debate over “active” versus “passive” management of funds (Investment Funds or ETFs) tends to distract from the fact that ETFs were not necessarily devised as a means to beat active management but more as a complimentary tool in the active investment managers toolbox. The lack of out performance by a statistically significant number of investment managers has naturally led clients to wonder why, if the active manager is trying and often failing to beat an index for a hefty management fee, the client wouldn’t be better off just buying that same index’s ETF for less and at least match the performance of the benchmark. Valid point, but not really the whole story. Especially in the enlarged context of ESG investing where considerations beyond traditional financial factors are integrated together with more holistic, non-financial considerations to achieve something more than beating a benchmark or maximizing performance.
Pension Funds Are Way Ahead
The “smart money”, as some like to call large institutional investors, are further along the transition toward ESG investment management ideas than the wealth management industry as a whole — that probably thinks it’s also smart but is lagging in innovation as a whole. Pension funds are the epitome of smart money because they don’t have a choice. They serve a very specific objective in terms of performance, but they are also beholden to increased constraints, scrutiny and oversight. As a consequence, they have had to deal with the issues of ethics and sustainability, to satisfy their reputational stability — performance, to fulfill their payouts to retirees and methodology, to ensure the oversight comprehends their processes.
What can we learn from the practices of the pension funds? In some cases, they have whole departments dedicated to their investment strategy that is usually farmed out to different institutional investment managers depending on their specialty, performance or both for implementation. One of their main issues has been with the metrics of non-financial factors in the investment process so that they can make comparisons, document decisions and generally apply coherent methodology. They have yet to agree on definitive industry standards for all types of ESG investment criteria, but they actively participate in many of the initiatives, both publicly and privately funded, to find consensus concerning the materiality of factors that influence ESG investment. Most have defined their own in-house standards, drawing upon different sources and models. But there is clearly no “one-size-fits-all” solution for the time being.
Private wealth managers might be able to learn from this and the specialized ESG investment managers are mostly already there. They often provide specialized funds that usually reflect the considerations and conclusions of smart money experience. Or perhaps they were the smart money to begin with. Whichever, the problem for smaller, independent private wealth managers is that their size doesn’t really allow for a department of ESG specialists to integrate the non-financial factors and data into their clients’ portfolios. The cost of having hundreds or thousands of individual client portfolios, each with their own ESG strategy and peculiar quirks seems inefficient and ruinous. But there are solutions.
Fintech to the Rescue
As fintech is enabling investment managers to automate most of the tedious tasks of their profession, we should justifiably expect more and more personalization to occur for smaller assets under management and at affordable rates. This is not in the interest of the multi-trillion-dollar investment fund management industry and indeed goes against that core, silent philosophy of “make money for the asset manager — clients be damned”. Wealth managers can expect a significant amount of resistance against a return to managed accounts as alternatives to funds. Especially since the biggest and the bad-est of the investment management industry are now spewing forth ESG-labeled funds. Some tax advantages incentivize larger clients to go with managed accounts and online ESG investment products are making it possible for smaller clients to invest as little as $5 with meaning and measurable ESG effect. The questions of shareholder activism and systemic change are not yet part of the mainstream concerns, but they should be.
There are still those medium sized independent wealth managers and RIAs that will have to eventually get with the program and integrate ESG into their investment process. They can seize an incredible opportunity to accompany clients in the realization that part of their careful risk protection includes incorporating and anticipating the non-financial risks or metrics into portfolios such as ESG factors. Clients should rightly demand it, if only to ensure that all risks are covered in their portfolio. And if the ESG solution on offer is a third-party fund, then it had better fit in tight with an in-house, client-specific ESG strategy or clients might find a more attractive, personalized offer elsewhere.
The smaller, truly personalized investment advisors and asset managers can reclaim the field by offering client-specific and tailored ESG investment solutions to their clients using managed accounts that allow the investor to see each and every security that they are invested in as well as continually adjust their investments to their ethical strategy and profile. Voting rights, stakeholder activism and strategies for encouraging systemic change are an integral part of socially responsible investing — lost with the proverbial ESG-labeled fund — a force for change which needs to be reclaimed by the conscientious investor if making a difference is really more important than ticking a box.
Originally published on Medium July 17th, 2018 https://medium.com/@jonathanjenny1/esg-investment-integration-beyond-ticking-the-boxes-b6ffb0de92d8