Friday HighlightFeb 18 2022

Why ESG preachers should take a wider view

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Why ESG preachers should take a wider view
Photo by Enrique from Pexels

Competition in the environmental, social and governance sphere is heating up, but the race is not necessarily all about assets. Some ESG investors will only select like-minded managers that focus exclusively on ESG, but relying on subjectivity and emotion may be a mistake. 

As the ESG space has burgeoned, propelled by a nitroglycerine-like performance boost during the pandemic, financial advisers and consultants are understandably searching for the best options for their clients.

Assets under management paint a confusing picture as experienced ESG boutiques are rapidly eclipsed by larger rivals, whose gargantuan marketing budgets have helped them hoover up investors’ ethically-focused cash.

So where to turn? Well, it seems that ESG specialisation is the defining characteristic that many believe sorts the wheat from the chaff.

The conviction in this is so strong in some quarters that some fund selectors, advisers and consultants refuse to accept that an asset manager can run traditional investment products alongside ESG offerings, and there is a growing tendency to mark such businesses down in the due diligence process.

Blinkered view

On face value, this might make sense. Why not choose someone whose focus is entirely on one thing, and who is passionate about this area?

The problem here is multi-faceted, but two aspects are particularly important.

Firstly, if a business has always done one thing and one thing only, there is an argument to suggest that they might not be able to see its pitfalls.

ESG is undoubtedly having its moment in the sun, but what does an ESG portfolio actually mean in terms of risk?

Intuitively, the application of filters and the introduction of active share relative to the market portfolio should negatively impact risk/reward characteristics. 

A traditional exchange-traded fund portfolio might comprise as many as four times the companies in it than an ESG or socially responsible investment equivalent, meaning investors are increasing their concentration risk, sector skew and geographic concentration.

Lack of objectivity

The other problem relates to the subjective nature of ESG investing. Investors would love to believe that the long-term performance of investing in sustainable companies will be superior to that of the broader market.

The belief is that because the strategy aims to do good ethically speaking, it will also do well financially.

This is attractive as a belief set but is not neatly supported by history. In fact, it is arguable that some sin stocks, notably tobacco, have traditionally produced outsized gains for investors – in tobacco’s case in spite of litigation and rising public awareness about the harm combustible cigarettes cause.

It does not necessarily follow that just because capital moves to sustainable stocks that they will do well ad infinitum and applying an ESG filter to a portfolio is a decision based primarily on conscience and principle, both subjective criteria.

Subjectivity is the prerogative of the investor. Asset managers should surely respect the intentions and preferences of investors, but should objectively apply expertise, science, academic findings and financial objectivity while doing so. 

A wide spectrum

As with most fields, the choice of manager depends on the circumstances and on the specific purpose and requirements of the portfolio. 

Elroy Dimson, chairman of the Centre for Endowment Asset Management at Cambridge Judge Business School, would argue that once you are divested, you have no influence over a company whatsoever. 

Impact investing sits very close to philanthropy on the ESG spectrum, where performance expectation is likely to be secondary to the primary goal of positive change. Here there tends to be direct involvement with target companies at a strategic level and is a clear need for specialist focus.

But for most investors impact will be separate from the core investment portfolio, and here the need is for selection and stewardship across a much larger universe of investable companies. This is where screening and weighting are key, and where traditional manager skills are the order of the day.

Investors need their managers to be specialised and focused not in belief sets, but in the management of robust, data-backed processes, and in the execution of client preferences in an unbiased and unemotional way.

Mark Northway is an investment manager at Sparrows Capital