The whole ESG — environmental, social and governance — investment industry is at a cross roads. Either something happens to make it effective and meaningful, or blind pursuit of, and irrational clinging to, outdated beliefs and practices will push the whole of society into a very dangerous situation, with a majority of people erroneously thinking “we’ve got this!”.
What we’ve got is confusion and some persistent business practices that are going to lead us toward unavoidable disaster. The unsuspecting client is not to blame here, but as the larger institutions elbow their way into the ESG field, protecting their bottom line obscures the intent of ESG — which is to save humanity from its own destruction. And incidentally, to save investors and asset owners from the predatory practices of short-term oriented businesses.
There are many deceptive issues and hidden contradictions surrounding ESG investment, some of which I suspect have been purposefully maintained and propagated by certain interests. There are myths; there are outdated beliefs; and there is a general resistance to put established norms and practices in question, which is the antithesis of one of the main tenets of ESG: Sustained curiosity.
Another is humility, but we won’t go there just yet.
Deceptive Issues and Hidden Contradictions
The most prevalent myth about ESG investing and understandably the most important one, is that in order to invest according to ESG principles, performance will be sacrificed. This is an important issue because unless you’re a unicorn trustafarian investing for leisure or pleasure, you are likely relying on the performance of your investments to achieve a financial goal — retirement, college fees, home purchase, etc. — and so if asked to choose between achieving your financial goals and helping some unknown population, issue or cause on the other side of the planet, it’s a no-brainer. You will invariably choose performance (masochists aside).
And indeed, if one were to define an investment strategy that excludes many of the stocks and bonds that are traded in liquid markets based on their involvement in unsavory issues pertaining to environmental, social and governance practices, self-imposed limitations would invariably impact the portfolio. But not necessarily the way one might imagine. In order to save the long and drawn out debate about performance vs. saving the planet for another article (and of which there are already many), let me say this: If the hard work is done to optimize the two in the context of a coherent investment strategy, research increasingly shows that retirement goals can be met, kids can be sent to college and homes can be purchased. The myth of performance vs. saving the planet is a carry-over from the times when ESG was called “socially responsible investing” and excluded companies with activities in tobacco, firearms and rogue regimes. That was over 30 years ago. To perform within ESG considerations requires deep data analysis, consistent questioning and optimization. It’s hard work, not a quick-fix solution provided by superficial scoring and “look the other way” compromises.
The next most frustrating deception is that ESG is an investment theme. You know, alongside sectors and ideas like “clean-tech”, “ageing population” and “the rise of millennials”. This means that if you have some “ESG” in your portfolio, you’re good. Unfortunately, you’re not good, you’re lost. You’re probably loosing out, because the fees on that “ESG” stuff in your portfolio are costing you extra and generally invest in the same companies as the non-ESG stuff with a sustainability score and some carbon footprint gobbledygook thrown in. Which, at the end of a reporting period, will lead you to say that ESG sucks, or suck it up and tell yourself that you took a financial hit for saving the planet. You’re not likely to be increasing your allocation to the “ESG” stuff anytime soon. Again, dilettante-ESG provides a weak investment argument, and ultimately discourages prolonged engagement with the subject.
Lastly, taken from my long list of myths and contradictions, is a key contradiction. How can we claim to be saving humanity (remember, the planet doesn’t need saving) if we fund, invest and support the very businesses that are destroying the environmental, social and governance conditions required for our continued survival? Financial firms are businesses too. Who in their right mind would saw the branch on which she were sitting, 300 feet above the ground? A large proportion of the companies that have reaped huge profits thanks to the very neglect of ESG factors, are now touting their support with token PR spending. You might not have noticed, but rarely are they suggesting the system be changed to avoid future plundering of resources — both human and environmental.
This brings us back to myth-busting, because many of the newly arrived players in the ESG arena have built their shark-like reputations in the ruthless pursuit of profits, at whatever cost, and can now be found lulling you into submission for your investment dollars and waxing poetic on their ESG capabilities, while diverting attention from their not-so-ESG activities.
One way to explain the irreverent re framing of the issues that ESG originally sought to address is that the financial industry amplifies many of the long list of cognitive biases that are listed on Wikipedia. Not surprising, since the financial industry today tends to be populated by some of the more conservative members of society. Not that conservatives are necessarily more prone to cognitive biases. We all are. But if you seek to keep things the way they are; if you’re convinced that all is well — then cognitive biases tend to be on your side. Perhaps by recognizing the surreptitious influence of some of these biases, the bolder members of the financial community will help to put each other’s opinions and beliefs in question. But I won’t hold my breath.
Take for instance, hyperbolic discounting, which Wikipedia defines as “… the tendency for people to have a stronger preference for more immediate payoffs relative to later payoffs. Hyperbolic discounting leads to choices that are inconsistent over time — people make choices today that their future selves would prefer not to have made, despite using the same reasoning. Also known as current moment bias, present-bias, and related to Dynamic inconsistency. A good example of this: a study showed that when making food choices for the coming week, 74% of participants chose fruit, whereas when the food choice was for the current day, 70% chose chocolate.”
The cognitive bias list is long and worth a read, but another of my favorites is irrational escalation, defined in Wikipedia as “the phenomenon where people justify increased investment in a decision, based on the cumulative prior investment, despite new evidence suggesting that the decision was probably wrong. Also known as the sunk cost fallacy.”
My point is that homo economicus is highly irrational, delusional and contrary to his own high opinion of his rational decision making qualities. This does not bode well for changing entrenched opinions and practices in a world where it has become urgent to do so.
“Real” ESG Investment
ESG investment is a process and a journey that is wrought with difficulty. It requires doubt, soul-searching, open-minded self-critique of the way things were accomplished in the past and a willingness to find solutions to improve them moving forward. However one approaches it, “real” ESG investing is hard work, both for the investor and the investment manager. It requires effort by the companies that are listed or raising debt to provide reliable and consistent non-financial data that can be used for extensive risk assessment. It doesn’t work well for clients who wish to invest and forget, unless they find a specialized ESG asset manager that they trust and who can do the hard work. Even then, they will need to think about their convictions and values and communicate them cogently to the asset manager to avoid unpleasant surprises.
As we are in a transitional period where many have not yet relinquished the errors of the past and there are no certainties with respect to the future, it becomes uncomfortable for investors and asset managers alike to be an outlier for fear of being destroyed by the steamroller of convention. But investment and asset managers (especially the larger ones, but rarely so) should be able to provide the human skills, the technical resources and the intellectual courage to move the ESG-standards needle towards holistic, three-dimensional evaluation of businesses for long-term preservation of continued conditions for human survival, environmental renewal and social well-being.
Following simple investment logic, better-managed companies that treat their human and environmental contexts with respect should outperform those that simply ignore anything other than the maximization of profit. To be sure, short-term maximization of profit might work, but the risk of getting caught — by legislation, regulation or a discerning public — would outweigh the benefits. In other words, ignoring ESG factors, adequately incorporated into portfolio construction is reckless, as it turns a blind eye to material factors that could adversely affect the value of investments. That is why just focusing on the numbers is an outdated approach to investment.
Who would knowingly invest in a badly managed company? Deep analysis of governance issues should help to asses the quality of management (and pretty much everything else the company does). Why would you invest in a company that is polluting the environment if it carries the risk of generating controversy, angering customers and killing locals? How short-sighted can one be in investing in a company that doesn’t pay their workers a living wage, attract quality talent and provide that talent with the conditions to excel in their workplace?
Ultimately, any of those short-term practices are doomed to fail, but surprisingly, they have been able to flourish in a global marketplace in which the risks are deliberately ignored, perhaps under the pretext that technology will find a way to fix our destruction, or maybe Jeff Bezos will have us all living on the moon by then. Kick the can down the road — somebody else will pick it up. Perhaps, but in planetary terms, who?
There are a lot of tools in the form of data, metrics, scores, funds, ETFs and on and on out there, but these are merely the materials with which a specialist is needed to construct ESG portfolios. The portfolios should be as individual as their owners. And this is where the bit about humility comes in. The combination of art and science, financial acumen and portfolio management techniques (many of which are beginning to look dated in the context of our highly irrational markets) requires constant learning, reassessment of methods, verification of data, relevance and then the patience of optimization, modelling and what-if analysis. Past methods are faltering in the expanded landscape of big data and non-financial materiality. The portfolio construction work is time consuming, sometimes reiterative and unrewarding, complicated and uncharted, meaning that it often needs to be started all over again to get it right. And then it needs to be re-examined regularly to remain relevant. Not an ideal way to make a quick buck and unfortunately not 100x scale-able. No unicorn material here.
Parkinson's Law of Triviality is described as “the tendency to give disproportionate weight to trivial issues. Also known as bikeshedding, this bias explains why an organization may avoid specialized or complex subjects, such as the design of a nuclear reactor, and instead focus on something easy to grasp or rewarding to the average participant, such as the design of an adjacent bike shed.” (Wikipedia).
ESG implementation is closer to nuclear reactor design and ESG-labeled products often fall into the category of bike sheds. In addition to technical financial skills, a certain culture is required to achieve effective and meaningful ESG portfolios, best defined by what it isn’t: No swaggering certainties, no hardwired economic beliefs, no standardized approaches, no limits to rethinking the status quo and certainly no false feelings of comfort derived from having been around for a 100 years or having a trillion dollars in assets under management. Complacency has no place in ESG investment because it’s a constantly moving target in an even faster moving world. The ESG specialist is constantly fighting against the biases that mislead us into the false comfort of “we’ve got this”. No miracle product, no quick-fix, no one-size fits all.
Fortunately, there are highly professional companies and capable individuals that are aware of the complexities of ESG investing who are up to the challenge and hard work of constructing viable, competitive and meaningful portfolios that are true to the basic objectives of ESG. But you have to look for these companies and individuals as they tend to not have the marketing budget of the big guys, which is why you probably didn’t even know you might need them.
If you’re an asset owner looking for effective and meaningful ESG investment, trust me, you need them. And preferably sooner, rather than “The Day After Tomorrow”.
Originally published on Medium May 16th, 2019 https://medium.com/@jonathanjenny1/the-critical-state-of-esg-investing-ed9ce1c8592