DON’T TRUST, AND PLEASE VERIFY! – The growth of ESG

There is both good news and bad concerning the explosive growth of sustainable investing (SI) over the past few years. On a personal level, I have seen more momentum on this topic in the last two years than I was able to observe in the previous twenty five. That new momentum is in itself the good news.
The bad news, on the other hand, is the inevitable and alarming parade of opportunists, poseurs, and hypocrites who are coming along for the ride (the sustainability cognoscenti pretty much know who they are, but their new clients are not so fortunate). This troubling phenomenon carries with it at least two dangers in my view. The first is that it exponentially increases the difficulty for asset owners — both institutional and retail — to separate the wheat from the chaff and identify firms which are genuinely worthy stewards of their capital. The second is that it basically dilutes and degrades the very concept of sustainability-enhanced investing itself.

Take no asset manager claims at face value; demand to “look under the hood” and ask some very tough questions about exactly how the putative ESG integration is being done.

Don’t get me wrong: there are definitely a number (and a growing number at that) of firms with both a genuine and long-standing belief and commitment to sustainable investing; they have spent years honing their craft, have robust methodologies, and merit our support. But I’ve witnessed a disturbing tendency among even sophisticated asset owners to confuse brand strength with rigour. Many investment houses are absolute ‘newbies’ in this space, and the approaches of some are cynical, opportunistic, and superficial in the extreme. If RFPs were a true meritocracy, many of them would struggle to even appear on shortlists, never mind actually win mandates. However, as long as career risk-aversion remains the most powerful driver of the behaviour of asset allocators, the sheer brand strength of some of the newcomers easily wins the day. In brief, I believe that it should not. It is a near-constant source of amusement to me that many of the firms now claiming to embrace (if not having invented) sustainable investing are the self-same firms that for decades either ignored or actively ridiculed the very notion that the ‘non-financial’ factors addressed by ESG could have anything but a blighting influence on their risk-adjusted returns. There are of course, even today, numerous hold-outs who continue to cling to this now-discredited mantra, and don’t even have the commercial nous to pretend that they embrace it. Perhaps they should be given our respect; at least they’re honest!This leads to my (entirely unsolicited) advice to asset owners and other fiduciaries and stakeholders: don’t trust, and always verify. Take no asset manager claims at face value; demand to “look under the hood” and ask some very tough questions about exactly how the putative ESG integration is being done. Where does the ESG research come from? How good is it? How exactly is it woven into the manager’s investment process? How much weight do ESG considerations actually have in security selection? What actual impact has it had on the contents of the portfolios? How does it really affect engagement with portfolio companies and candidates?
My regrettable conclusion is that, for many of the arrivistes, ‘ESG integration’ has so far been cosmetic and superficial at best – essentially a cynical marketing ploy to access the cornucopia of assets now being made available by the growing ranks of PRI signatories. To me, the real acid test occurs when interrogating the organisations’ Chief Investment Officers. I have personally spoken at length to dozens of them from all over the world. Most of them are, of course, devout signatories of the PRI, Carbon Disclosure Initiative, and virtually any virtuous initiative to which they can affix their organisation’s name. But I struggle to think of a full handful of CIOs who, despite the mounting empirical and academic evidence, genuinely believe that a well-constructed, sustainability-enhanced portfolio can actually improve its risk-adjusted returns.
But why is that the case? In my humble opinion, it is because embracing sustainable investment flies directly in the face of the two most powerful forces of nature: individual intellectual inertia, and collective organisational inertia. On the personal intellectual side, conventional ‘wisdom’ in the finance world has long held that ESG considerations are at best financially immaterial, and at worst (and more frequently) they are actively destructive of returns. This conventional view has dominated financial thinking for decades, and old habits die hard. At an organisational level, there are a plethora of barriers: trustee reticence, an obsolete interpretation of what fiduciary responsibility entails, and of course the old reliable: career and ‘maverick’ risk aversion.

All of this is simply to say two things:

• It is statistically unlikely that your would-be sustainable asset manager will actually deliver you the goods;
• It therefore behoves you as asset owners to scrutinise their sustainability claims forensically.

Having said all this, let me end this short missive on a more positive and optimistic note: there definitely are some good, committed and genuine asset managers out there in the sustainability space. It takes some effort to distinguish them from their opportunistic, big-brand rivals, but the effort should be well worth it. The prize could be not only better risk-adjusted returns, but also positive real-world impact.

Matthew Kiernan is CEO of Inflection Point Capital Management