From Rhetoric to Practice

ESG investing plays to active managers’ traditional strengths, but they must also master new skills and metrics, says Patrick Ghali, Managing Partner, Sussex Partners.

The question as to whether investors are better served with a passive approach rather than employing active managers is one of the most fundamental debates in investing. Proponents of the passive approach often tout the lower cost and the fact that markets, over long periods of time, have a tendency to go up. While this may be true for traditional long-only markets (not withstanding that different time periods may lead to wildly different results), the question becomes a lot more complex when investing to manage environmental, social or governance (ESG) risks or to achieve UN Sustainable Development Goals (SDGs).

Many passive indices, especially the main benchmarks (e.g. S&P 500, FTSE 100 and Nikkei 225) are failing to take ESG/SDG-related objectives sufficiently into consideration. Let’s take inferred temperature increases represented by investment choices as one example. The Science-Based Targets initiative estimates that the companies that make up the primary G7 equity benchmarks imply an average temperature rise of 2.95° C. This would be nearly double the 1.5°C target set by the Paris Climate Agreement, and clearly demonstrates that passive investing in the main benchmarks is not aligned with ESG/SDG targets, and hence detrimental to the long-term health of our planet. The global economy, as it stands today, is clearly not yet geared towards sustainable development and the main global benchmarks reflect this.

Creating confusion

While recent years have seen multiple new indexes that purport to be ESG/SDG focused, it is concerning that these all apply different selection criteria, and that companies that may be excluded from one index can be ranked very highly in another. This not only creates considerable confusion among investors but exposes them to accusations of greenwashing, as well as the risk of holding investments that are not aligned with their own ESD/SDG requirements. Clearly passively allocating to the main benchmarks will do little in terms of aligning portfolios with ESG/SDG considerations, and even utilising newly set up ESD/SDG benchmarks may not lead to the desired results.

The same issue is present with exchange-traded funds. While many investors like the ease of use and low cost of these products, simply having an ESG label doesn’t guarantee that all is as it seems. Questions are now being asked as to whether this could lead to a massive mis-selling scandal. More publications are picking up on this issue, including the Financial Times[1]. What is beyond doubt however, is that the ‘green’ label helps to attract significant asset flows. According to Morningstar, US$142.5 billion was invested into sustainable funds in Q4 2021 alone.

Notwithstanding the concerns around benchmarks and passive instruments, ESG/SDG investing is experiencing a sustained mega trend in terms of capital being allocated to these types of investments. And just as well!  The United Nations estimates that getting to net zero carbon emissions will require investments of US$32 trillion in the next 10 years.

Capture the opportunity

The sheer magnitude of money flow will undoubtedly lead to extraordinary opportunities. But as is so often the case when a lot of capital needs to be deployed quickly, misallocations of capital will also be rife. It will be extremely difficult for passive investments to fully capture these opportunities, to avoid those companies that will fall by the wayside because they have not adapted quickly enough, or that are simply going up in price due to hype rather than substance, and therefore should either be avoided altogether or treated as short selling opportunities. Navigating changes in policy, reconciling these at a global/local level, while at the same time understanding the rapidly developing technology landscape should benefit specialised and properly resourced active managers.

Emerging investment focus areas such as ESG/SDG, typically lead to inefficient capital allocations, and opportunities for in-depth analysis to yield significant alpha for investors. Unlike traditional and efficient markets such as US mega cap equities, for which extensive research coverage exists, ESG/SDG investing will require a different set of skills and knowledge discovery for some time to come. The managers best suited for this will combine a robust investment and risk management framework, with support from credible experts in ESG/SDG.

This often comes in the form of partnerships with not-for-profit organisations with a long history in a specific ESG/SDG segment or academia. Some of the largest or most sophisticated managers will be able to put together and appoint highly specialised advisory boards solely focused on ESG/SDG, some of which may even have veto powers over certain investments to ensure proper alignment. Other managers are now tying parts of the performance fees to hitting quantifiable ESG/SDG goals and not just return targets. As ESG/SDG investing becomes more mainstream, some of these opportunities and inefficiencies may dissipate, but in the early stages there should be plenty of potential for alert and well-organised active managers in this space.

Pivotal role

For these reasons, active managers should play a pivotal role in the further progress of ESG/SDG investing. Not only will they be able to ensure proper alignment of investor requirements and ESG/SDG compliance, but they should also be able to better gauge which companies will benefit from this mega trend, which may suffer, and which may simply profit from too much froth in the market (and thus be candidates for shorting).

This then brings us to the next important point, which is how to move from rhetoric to practice. While it seems that passive investments are not truly suited for the implementation of a cogent ESG/SDG investment strategy, active managers are increasingly well positioned to properly measure and monitor adherence to stated objectives. Rather than rely on somewhat arbitrary ratings systems, or flimsy labels, more sophisticated types of classification systems are developing which take rankings to a new level by applying detailed, quantifiable measurements on which companies can be judged.

These, for example, might quantify a company’s contribution to global warming versus the Paris Climate Agreement’s stated goals or measure the impact of a company’s environmental footprint in hard currency terms. This is especially important as investors begin to realise that many companies which appear at face value to be profitable, would not be so if a cost was applied for the negative externalities (beyond just first order impacts) that their actions impose on the environment. Active managers are well placed to apply such factors in their portfolio construction to better understand the real profitability of those companies, as well as potential dangers to which positions may be exposed due to the impact of their externalities.

Capitalism as catalyst

Ultimately, ESG/SDG investing may well become a normal part of any decision making process, and it isn’t inconceivable that the distinction between ESG/SDG and non-ESG/SDG investing completely disappears over time as society at large won’t allow companies to generate (inflated/fake) profits by excluding the cost of their negative externalities on the planet and populations. The closely followed ‘Dear CEO’ letters by Larry Fink of Blackrock, and similar initiatives by other market-leading investment firms, are clear harbingers of this progress. Institutional asset managers, and more importantly, their clients, are no longer willing to accept the status quo and are asking for a rethink of capitalism and the role it can play in being a catalyst for positive change.

However, until such time as the inclusion of sustainability goals becomes a sine qua non, active managers will continue to play a central and critical role in generating excess returns for investors while ensuring that ESG/SDG goals are truly met rather than simply representing a buzzword used to raise more capital.

[1] Green Investing – risk of a new mis-selling scandal by Laurence Fletcher and Joshua Oliver, Financial Times 20.02.2022

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