This article is free, but to access more of our content, you can sign up for a no strings attached 28-day free trial here.
I use the word ‘hysteria’ here with some caution, for I don’t entertain climate denialism, but do remain open to evidence pointing me to a different point of view.
I attach the word to the rapid flows occurring currently into ESG investment products. It displays herding behaviour and how it relates to the Efficient Market Hypothesis (EFM) of Samuelson and Fama.
In US economist Eugene Fama's influential 1970 review paper, he categorised empirical tests of efficiency into "weak-form", "semi-strong-form" and "strong-form" tests. These categories of test refer to the information set used in the statement "prices reflect all available information". Weak-form tests study the information contained in historical prices. Semi-strong form tests study information (beyond historical prices) which is publicly available. Strong-form tests regard private information. No doubt brighter academics will test ESG investing against EMH – albeit that, given the rapid rate of change, I do not think the data can be suitably constant to test a hypothesis or its nil value. It’s being commented on out there, such as in this piece.
Understandably, analogies are being made between the race to invest to meet Paris Accord targets and the dotcom bubble of the late 1990s. Not all comparisons stack up, but some do. Nicolai Tangen, the new CEO of Norway’s $1.3trn pension wealth fund, has expressed his worries about climate investment bubbles. He also suggests that frothy prices might reflect longer-term potential, as they have with big tech stocks. In other words, many argue that the long-term ‘K wave’ justifies any short term inefficiencies. The greater good!
Yet echoing debates are currently bouncing around the virtual walls of just about every boardroom and investment committee.
With the cause for investment ‘transition’ consensually just, we should assume that the migration of capital to green will be expedited. But speed and risk do not always square well. Rather, rapid asset transition may prove to be an inefficient period of allocation, and thus we must be vigilant towards unexpected risks. As an undeniable Minskyist (Hyman Minsky being noted for his debt cycle model) I am particularly wary of periods of high debt culminating with low rates of borrowing combined with a rampant, ravenous demand for new climate-linked products.
Jérôme Tagger, CEO of Preventable Surprises, the sustainability think tank, on our recent podcast episode of my New Fund Order podcast, reminded us of the comment of Chuck Prince, then CEO of Citi in 2007 during the financial crisis, with a slight paraphrase of what might happen now: “When the music stops in terms of liquidity, things will be complicated, but as long as the music is playing, you've got to get up and dance'.
Listen to that podcast here.
The comment elegantly describes the current race to ESG, buoyed with government and corporate liquidity across public and private markets.
If there is a backdrop of market inefficiency, then this has a large bearing too on ESG tilted indices and ETF use. They are cost efficient of course, and in some strange product strategist’s venn diagram they promise a beautiful nexus. Yet such products can also pose inefficiencies, reducing the effective capital allocation to reach Paris targets, all given up to make UN PRI quotas easier and provide those punchy headlines to investor relations teams.
Nonetheless, they are attractive to investment committees because they offer a more orderly and gradual transition that does not blow the budget (risk) from large scale divestment. The trend is certainly moving in that direction.
However, indices alone provide no activist component, which I believe is needed to deliver an efficient climate transition. I am pleased to see that ETF providers (and Vanguard) are getting more engaged. That seems like common sense to me. But indices rarely divest their worst offenders and, having worked with them over the years, I’ve observed that index construction rules are often narrow in both intent and outcome.
This is mostly the fault of asset owners; at their behest the ‘green’ screen gets dialled back to satisfy the status quo: ‘Whatever happens, don’t blow the tracking error!’ they say.
Most investment committees want to do ‘good’ but not at the risk of getting beaten up by the broad market. However, this approach looks ungainly and intransigent on issues such as Tesla and BooHoo.com. There is still a vague remoteness between investment committee bubble thinking and the impact of their decisions. The forces of hesitancy and conservatism – so prevalent among institutional investors – whilst understandable, encourage further gradualism. Hopefully, this will change in time as the broad market becomes less distinguishable on an ESG screen.
Therein we have lots of data but little by way of indicators to help measure capital allocation efficiency into ESG products. Weighted Average Climate Intensity (WACI) is increasingly common, but pretty blunt and inconsistent from data provider to provider. The work of the Task Force on Climate-Related Financial Disclosures (TCFD) will undoubtedly help here (we hope) but only for future carbon pricing and allocation. The ‘elite’ and political class obsession towards carbon ‘above all else’ will have a secondary effect of creating inefficiencies in other areas of ESG, unless checked.
For those who believe in the Darwin-like abilities of market cap pricing and low cost indexing; yet want some sustainable kudos points, then the appeal of ESG-tilted indices are obvious.
I caution you though to look at whether every pound spent, and each unit purchased, actually drives climate transition targets, and in a manner that does not pose unexpected risks to investors. The answer is that it’s not even close. Thus, if there is inefficiency in allocation into listed index constituents then this will get automatically enveloped into ESG indices without challenge. The greatest misnomer today is that £1bn invested into a tilted index is £1bn invested sustainably. Yet, the label allows investors to proxy and report that it does.
At the other end of the allocation spectrum, and perhaps of more immediate concern to investment committees, are private market impact funds where price efficiency, liquidity and financial structures are complex and even less transparent. The point, however, is similar: the desire to identify the asset and deploy the capital at haste is a recipe for inefficiency and risk. I note that some asset owners are taking large investment strides here. This is laudable, but I can imagine such rotations will keep their governance committees very busy. Put another way, I truly hope that is the case, or else I would be worried as a customer!
Another example of ESG inefficiency is the scant amount of engagement/information between actual end investors and those engaging investee companies on their behalf. There is so much volume in stewardship and proxy voting product right now that it could be compared to a greenwashing elephant hiding in plain sight.
This is particularly the case for super-sized passive funds and ETFs with huge stock registries. This is where the work of NGOs like ShareAction, IIGCC and more sophisticated ‘selection, appointment and monitoring‘ practices by larger asset managers should make a difference. As asset owners develop their ESG policies and attempt to engage their investors directly then this will cause frictions back along the value chain with suppliers. This will proffer a big challenge for fund investors, advisers, passive providers, ETFs and active managers alike.
Partly, the underlying issue is index manufacturers, who are focussed on data and choice; that’s a good and bad thing. The word “choice” is such a great cover-all for wider greenwashing. It shouts ‘we’ve done our bit’, ‘here, if you want’, without doing much more than some fairly straightforward spreadsheet reverse-engineering; a nip here, a tuck there. If an investor buys, then ker-ching, switch on the index licensing fee.
Index concentration and proliferation are a problem. Just offering more choice doesn’t get the job done. It actually devoids us of any notions of the usage, suitability or efficiency of what is being tracked. There is no stewardship or governance here; only data.
Helpfully, index manufacturers provide us with copious amounts of meta research that will improve decision science. But, when the gravitational pull of the S&P 500 or the weight of China in emerging markets indices remains so strong, then do I think index manufacturer committees should be more engaged? This puts even greater pressure back onto investment allocation committees to recognise the agnostic nature of indices, identify their uses, their shortcomings, comparability with their own investment policies, and then try best to match. Perhaps it leads to a green form of core-satellite allocation. I hear governance debates along these lines. Asset owners should already be engaged with a proxy voter and their asset managers in order to take up the engagement void that indices leave.
Investment committees must balance a number of considerations. ESG tilted indices serve a purpose but many ask why the mainstream indices are not tilted to ESG by design; rather than conflated under the guise of ‘choice’. On that point I am left undecided. However, until it is addressed, active and index approaches will remain useful. ESG efficiency must become evidence based.
Ultimately, for markets so clearly wedded to Efficient Market Hypothesis (EMH) post GFC, the rush to green-tilting through ETFs and index investing looks odd. There is a lack of information or price efficiency when it comes to tilting or ESG investing generally. Perhaps that’s a problem for the EMH; perhaps it’s a problem for ESG?
JB Beckett is an ex-fund selector, non-executive director, emeritus of the Association of Professional Fund Investors, external specialist for the Chartered Institute for Securities and Investments and author of books including New Fund Order.