Op-Ed: Matthew Kiernan: When is ESG integration not ESG integration?

There’s much less progress being made than meets the eye

Let’s stop patting ourselves on the back, shall we?

As someone who is this year marking his 30th anniversary in the sustainable investment (SI) space, I’d like to think that I’m as aware as anyone of the huge progress that’s been made over that time, and particularly over the past five years.

And although the quoted numbers about its market penetration are invariably generous if not outright apocryphal, it is undeniable that real progress has indeed been made.

In addition, on the face of it, the recent tsunami of “sustainable “ funds would also seem to bear witness to this progress. Alas, however, I am convinced that there’s actually much less progress being made than meets the eye… and no number of self-congratulatory conferences and industry association publications can change that sad reality. It’s past time to get real!

As an aside, I remain an opponent of various schemes to standardize and certify “sustainable” investment products.

To me, that makes no more sense than trying to standardize and certify both substance and process for equity investing or for any other asset class. Who, for example, would try to tell Fidelity that their global equities fund hadn’t been put together properly or considered the “right” factors?

But, that said, let’s have at least a modicum of decency and integrity when making claims for the sustainability of various funds and investment products!

If I had a pound or a dollar for every global equities fund which has recently been “repainted” as an SDG, climate or sustainable one with no substantive changes to the portfolios inside, I’d be a wealthy man.

Of course the tricky thing about ESG integration is that it’s extraordinarily easy to claim, but devilishly difficult to disprove, unless one is an insider and has complete visibility into the portfolio construction process — which is impossible for outsiders.

So take a hypothetical claim from the hypothetical Hypocrites Asset Management: “ Of course we practice meaningful ESG integration here! How dare you doubt us? Can you prove that we don’t?

“Why, here at Hypocrites, we have a deep and long-standing commitment to sustainable investment. We’ve been practising it for a long time: at least six months!”

The result is that it’s become tremendously difficult for asset owners to separate truth from fiction.

A huge marketing budget, hosted webinars and speeches do not a sustainable investor make!

Let me provide a concrete example.

Factor-based investing is currently flourishing in the mainstream investment world, at least among institutions. Two years ago, one large asset manager introduced a major innovation: a new, multi-factor index fund which added climate change to the usual, more traditional array of factors (low volatility, momentum, growth, value, etc.).

And the new strategy quickly attracted over £2 billion in investment, from sophisticated institutions. I applauded this move at the time, and even now consider it a major step in the right direction (it has since been flattered by several imitations).But when I began to reflect more carefully on the new fund, a key question occurred to me: it’s all well and good to address climate risk, but just how much weight or emphasis did the carbon factor receive in the overall index “tilt”?

Since we know that there were five factors in total, and that the total tracking error to the mainstream benchmark was miniscule (hence the ability to attract lots of assets quickly), the total “bet “ on the relevance of climate analysis was pretty derisory.

“It’s become tremendously difficult for asset owners to separate truth from fiction.”

Let’s pretend that all five factors were weighted equally. That means that the emphasis on climate change was equal to roughly five one-hundredths of one percent of the decision-making process -– hardly a major statement of policy intent or conviction.

Now, unquestionably there has been ESG integration here (which I applaud in principle), but did it constitute real integration?

Contrast this with a nearly contemporaneous move by Swedish public pension fund AP2.

Again, a multi-factor index was funded and launched, with climate added to the usual mainstream menu of factors. But in this case, the climate factor received the heaviest weight of all.

(Again, the overall deviation from the “plain vanilla” index was modest, but at least climate became ‘primus inter pares’.)

That, to me, feels more like genuine ESG integration. An even more dramatic example of a climate focus is one equities fund from a European asset manager, where climate considerations are given equal weight to the traditional financial factors such as price, profitability, and so on. Now that’s integration!

So, for me at least, the important thing is not that there is some use of ESG factors, it’s a question of how much emphasis do they receive?

How much of a role do they play in deciding which securities to buy, and how many?

If, as is too often the case, they’re looked at only cursorily and ultimately have zero or minimal impact, it’s a real stretch to call that “ESG integration”.

Meaningful integration requires ESG factors to be taken seriously, from the very outset of the evaluation and selection process, and has to make a material difference to the results, vis-à-vis an ESG-free approach.

If we take that as our litmus test for meaningful integration, it’s anybody’s guess as to what percentage of the PRI’s $70 trillion in signatories is actually making good on their commitments and practising ESG integration.

I’d be pleasantly surprised if that figure were as high as 25% and I’d be delighted to be proven wrong on this.

Now, when that figure hits 80%, THEN I think our industry should be permitted to pat itself on the back. Until then, not so much…

Matthew Kiernan founded Inflection Point Capital Management, where he remains Chairman, and Innovest Strategic Value Advisors.