By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
Over the last few months there has been a series of negative media articles about “ESG” and critical comments from high-profile figures such as Elon Musk and Mike Pence. In these articles, tweets, and speeches, the common thread is that ESG is a silver bullet intended to weed out “bad” companies, drive social and environmental impact, stop climate change, and other “woke” objectives. With decades of experience in sustainable investing (SI), we know that there are no silver bullets anywhere in markets, no shortcuts, no onesize-fits-all. We also know that words matter and if we are not speaking the same language, the result will be confusion and misunderstanding.
Let’s start with a few facts. Investors can’t solve all the world’s problems; governments, companies, and consumers must all take action. Clients do not all have the same objectives, so different approaches to SI are required. ESG is just one of a number of SI approaches and is often used in combination with other approaches.
The history of SI is often described as an evolution, though in reality it was more an ongoing development of new approaches that are all relevant and widely used today. Decades ago, there were two primary SI approaches, exclusionary socially responsible investing (SRI) and activist investors pushing companies to improve behavior and transparency. Both SRI and activist investors were often driven by ethics or values. One of the most important outcomes of the SRI and activist movement in the latter part of the 20th century was an increase in transparency from listed corporations.
Improving corporate disclosure enabled a more rigorous approach to assessing the environmental, social, and governance (ESG) risks corporations face. The spark that created ESG can be tied back to papers written in 2004 titled Who Cares Wins and The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing. These papers and the work done by the United Nations Environment Programme Finance Initiative led to the formation of the UN Principles for Responsible Investment. The conversation shifted toward material ESG issues that would resonate with institutional investors and leverage capital markets to better measure and manage ESG risks. Nearly a decade later, research from Harvard and other prominent academic institutions began to show that integration of material ESG factors into the investment process could result in improved risk adjusted returns, primarily through the reduction of risk.
Over the last twenty years, environmental and social thematic and impact investment approaches have gained scale and are growing rapidly. Unlike exclusionary or risk-based approaches, thematic investing seeks to target or emphasize investments aligned with one or more environmental or social growth themes. Impact investments often target similar environmental or social challenges, though unlike thematic investments, driving direct and measurable outcomes must be a primary objective of impact investments.
As client interest in SI has grown, so has product development and marketing by financial firms. Unfortunately, with this growth, terms have been used interchangeably and “ESG” is often used as an umbrella term. The lack of agreed-upon terminology combined with a marketing-driven narrative have created confusion.
The integration of ESG analysis into the investment process can help investors manage risk by comparing how companies measure and manage the material ESG risks they face relative to peers. ESG integration will not weed out all companies subjectively considered morally or ethically abhorrent, nor will it explicitly target companies with products or services aligned with a more sustainable world. While ESG at scale may harness capital markets to drive positive outcomes at the systems level over time, it will not result in direct, tangible, or intentional impact at the micro level.
The approaches outlined above have different risk/return profiles and different key metrics used for implementation. Additionally, clients have different time horizons, risk tolerances, return objectives, and financial goals. Some clients may want to avoid certain types of companies, while otherwise seeking diversified market exposure through a mix of stocks and bonds. Some may seek higher returns by targeting certain environmental themes through stocks that may offer higher levels of growth, though not without the potential for higher volatility and perhaps other risks. Matching investment solutions with client objectives and risk tolerance is critical to meeting client expectations and more broadly to reduce confusion in the industry.
While recent media attention is justified by the state of confusion, the path to a stronger and more durable SI industry is being laid by regulators and industry organizations. We are encouraged by the recent release of the CFA Institute’s product level disclosure standards and the US SEC’s push to improve both corporate and investment firm disclosure and communication. These are important steps to reduce confusion, build a strong foundation for future growth, and improve alignment with sustainability objectives.