Everyone believes it works, but few are actually practicing it. That is the verdict on full ESG integration into investment decisions, according to a new paper by Michael Cappucci, a senior vice president at the Harvard Management Company. He opens the paper by saying: “If investment managers followed the old saying ‘whatever is worth doing is worth doing well,’ then more would have best‐in‐class environmental, social and governance (ESG) programs.”
In the past, asset owners could tell whether an investment manager “got” ESG investing principles by asking whether they had a written ESG policy. But now, written policies are everywhere, but it has ceased to be an indicator of any kind of commitment to sustainability. Yet still, he concludes, most asset owners and asset managers believe that: “integrating ESG factors in the investment process in a way that mitigates ESG risks and capitalizes on ESG opportunities” is going to bring alpha [excess returns vs. a benchmark].
But if so many asset managers have spent time and money on figuring out what ESG factors are, you would think they would want to get a return on that investment. Cappucci finds, however, that there is a paradox in this adoption: “if the greatest benefits of ESG incorporation are achieved only through the full integration of ESG factors into the investment process, why have so few investment managers adopted the strategy?”
Asset owners that rely on external managers can face the same risk of negative ESG drag, the lack of full integration therefore the lack of the full benefits, when choosing a manager and so should take this potential paradox into account when making a selection.
Cappucci defines the gold standard for sustainable investing as the “full integration of ESG factors into the investment process”. But he warns that managers seeking to integrate ESG factors “face a kind of J‐curve in which the majority of the costs are borne up front, and the benefits are not realized, if at all, until well into the future”.Those added costs might result from losses resulting from the exclusion of certain stocks or the purchase and integration of ESG data. The best results are that the costs are passed on to asset owners and offset by better performance. But if ESG data is not integrated properly, then performance suffers and worsens the increased cost effect.
“Why have so few investment managers adopted the strategy?”
While all this is widely recognised, according to a recent State Street survey, only 21% of institutional investors use full ESG integration. A finding that Cappucci confirms from a host of other surveys. These surveys conclude that integration is discretionary and unsystematic. And that, apart from the publicly‐listed behemoths and a select group of SRI boutiques and ESG true believers, most US asset managers are operating well short of the ideal.
Of course, there are barriers to integrating ESG factors, such as lack of standards, lack of comparability, lack of company ESG performance data and so on. In addition, Cappucci notes, manager incentives are out of alignment with ESG integration as they are still based on 1‐, 3‐ and 5‐year time horizons, while the timeframe for ESG results is longer than any of these.
Cappucci concludes that, for asset owners, it is best to choose managers on the upward curve of ESG integration; which he indicates as those with positive ESG momentum, defined as improving ESG scores, and strong intentionality, in other words ‘they really mean it’, in their investment approach.
Of course, this leaves us with the issue that if every manager was already operating at the gold standard, there would be no one on the upward curve. So choose your positive momentum manager quickly.