Investment in companies that integrate environmental, social and governance factors continues to gain traction across public and private markets.
Once considered a niche, the zeitgeist has gone past the notion of a ‘seismic shift’. Instead, integration of ESG underpins most, if not all, debates about the future of the investment industry.
This aligns with broader commentary on stakeholder capitalism, new forms of corporate governance and an understanding of corporate purpose.
The question is, will all active management become ESG-focused?Two prominent investment themes over the next decade will be the integration of ESG across portfolio management and corporate business models, alongside artificial intelligence resolving many of the challenges in achieving the former.
While the industry contends with the concept of ESG, from the known to the unknown, there are several structural shifts at play that investment managers must contend with.
Thematic funds are here to stay
Historically, larger investment managers were concerned about a notable diversification of their investment offering. Thematic funds became the flavour of the moment and were explored to take advantage of long-term momentum and market cyclicality.
Trends in sectors such as consumer non-discretionary, healthcare and financials have been very popular with thematic managers who saw value in focusing on a sector and matching the investment horizon of institutional and private clients exposed to equities.
ESG was likely of little concern at the time. Not too long after, and potentially coinciding with the rise of passive investing, diversified offerings began to seem scattered and unmanageable.
Larger houses found themselves in situations where the need to standardise overtook their desire to offer diverse products.
Their clients appeared to have too many options to choose from, at a time when investor appetite began to turn risk averse. Many investment managers adapted by incorporating impact themes to re-introduce a new set of thematic funds that focused on ESG.
Passive indices support ESG investing
The growth in benchmark offerings by index providers is giving a clear advantage to passive investors tracking the index. The Domini 400 Social Index (now, MSCI KLD 400 Social Index), was launched 30 years ago. Today, there are more than 1,000 ESG indices.
However, passive strategies have been slow to react to the growing importance of ESG, leading to potential reputational challenges. Without including ESG-specific factors in passive strategies, the growth in ETF investing over the past 20 years has resulted in major providers becoming some of the world’s largest investors in carbon-intensive industries.
This has not escaped the attention of environmental activists. To address this balance, there has been a recent deluge of new ESG passive strategies launched to market. Despite this, it will clearly take some time, and asset flow, before passive investing can escape this undesirable association.
Sustainable investing goes mainstream
Career analysts may breathe a sigh of relief that one of the two biggest emerging themes in the current landscape is a familiar opportunity to stay relevant. Investment managers who treat this as another temporary change in investor appetite could find themselves left behind.
Their competitors are correctly identifying the need to change and allocate resources to support a long-term outlook.
The question is, will all active management become ESG-focused? In the short-term, there is evident demand for actively managed ESG strategies. Some investment managers are reporting that inflows into ESG strategies have outstripped other asset classes, including passive equity.
Product categorisation requirements under the EU Sustainable Finance Disclosure Regulation is bringing this theme into focus.
Among some distributors, categorisation under SFDR article eight and nine is being seen as a badge of ‘sustainability’, with some asset managers experiencing pressure to categorise their products under these ‘green’ banners to satisfy investor demand.
For other managers there is greater caution on SFDR product categorisation, with compliance risk superseding commercial opportunity, at least in the short term. As the market standard becomes more clearly defined, we are likely to see ‘product shift’, as funds move in or out of these 'green' classifications.
In the longer term there are other dynamics at play, not least investment performance, which will be a major contributing factor to the continued demand for ESG-based strategies.
On the whole, it is difficult to quantify the performance of ESG funds vs non-ESG/traditional financial products. Regulation is driving transparency, alongside industry efforts to standardise. If this moves at pace, in time we will have reliable evidence to validate this perspective.
AI: A friend to passive and an ally to active
When this decade’s two biggest themes in investment management meet, the potential to make a strong impact on responsible investing is promising. AI will be of benefit to both active and passive investors.
There are a growing number of technology companies and boutiques that tackle both challenges with large seed capital investments and senior appointments. They publish impressive sets of scores and develop tools to capture daily changes in ESG performance, seemingly making it easier for investors to access information.
The input of a human analyst is still required in order for this to work. For starters, unreliable ESG data needs to be identified and removed. Active investors and analysts may utilise technologies like sentiment analysis algorithm, to pair it with their fundamental research in order to remain competitive.
There is also a large scale cultural and educational consideration in respect of this.
With a new and improved set of investment principles that fit well into the fundamental equity research world, ESG has found a place in index methodologies.
Once these inefficiencies are addressed, there is plenty of scope for both active and passive investors to benefit from the winning combination of AI and ESG.
It is clear to see the investment management sector is at the beginning of a substantial and sustained structural shift, with multiple dynamics at play.
ESG integration is no longer optional, but expected, and is already driving a significant change in mindset across industry.
Katherine Lampen is sustainable finance lead at Deloitte
