InvestmentsSep 9 2020

ETFs make ESG transparent

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It should be a game-changer. 

However I am not yet convinced that many IFAs are ready for this change.

The compound effect of MiFiD, Prod and the SMCR changes has left many, despite their best efforts, struggling to keep up. They want to focus on their business, not more regulatory changes. The impact of Covid-19 has also proven to be an unwelcome distraction.

To date many have taken little or no action to prepare, but the MiFiD II changes cannot be ignored.

Inevitably panic will set in and we will soon see a huge increase in demand for clarity through marketing materials, better education on the topic and greater interest in the investable universe.

Fund Managers will be emailing out marketing materials. Any marginal out-performance from any fund claiming to be ESG-compliant will be held up as “proof” that they are the next big thing.

The invitations to ESG conferences will be coming in thick and fast (albeit many will be virtual).

But I fear there will be a huge gap between the specialists – those steeped in ESG history - and what the advisers can cope with right now.

We do not even have a common language around ESG within the IFA community to help differentiate between ethical investing, ESG investing and socially responsible investing let alone a long list of research analysts with a track record and skillset to properly evaluate ESG investment opportunities.

In trying to develop a common understanding, if not a common language, I try and explain ESG along the following lines: 

Ethical investing is where investors’ social and moral preferences are factored into the investment decision-making process.

To ensure there is a sufficiently broad investable universe these preferences have been extended to include ESG-related factors into investment decisions.

ESG factors include climate change policies, carbon footprints, recycling, ethical supply train sourcing, employee engagement and board level diversity.

ESG helps identify potential risks and opportunities beyond the traditional approach to valuation.

SRI goes one step further than ESG by actively eliminating or selecting investments according to specific ethical guidelines. SRI often relies on ESG to apply additional positive or negative screens into the investment universe.

The broadening of the investable universe has led to major changes in corporate behaviour, which is having a positive impact on investment performance. 

Funds investing in companies with strong ESG policies have, contrary to a widely held view, out-performed their benchmarks in recent years. 

To attract investors interested in ESG, thousands of companies have looked to re-assess their relationships with their customers, employees, suppliers and the wider community – and this has undoubtedly helped their performance.

It was also good to see that even at the height of the Covid crisis, companies which scored highly against a set of ESG criteria performed well.

The corporate changes have often come about “below the radar”, a subtle cultural shift away from a short-term approach to a much more strategic one. It would appear to be a win-win situation for everyone.

But while the investment universe has broadened, investment performance has improved and liquidity has increased, there is the danger that in all the excitement, we may find ourselves in a dangerous bubble.

Unlike with ESG, when emerging markets investing first took off there were local experts already in place to help with the due diligence process. Sometimes their quality was poor, but there were at least plenty of options. 

With ESG it is different. 

Although various consultancies have made good headway in identifying ESG investment opportunities over the last couple of years, over the next few years we see a tsunami of new esoteric funds and fund managers emerge.

Many of these will be very specialist and will not have been subject to proper scrutiny.

There simply will not be enough trained analysts or consultants to carry out the required level of due diligence. Similar to the IFA network, the industry is not sufficiently well-prepared.

Mistakes will be made and investment performance could suffer as a consequence.

There is a danger that the goodwill surrounding ESG investing could quickly evaporate. If that happens we could well see a slowing down – if not a reversal – in the number of corporates willing to change the way they operate. 

Perhaps the only way around this dilemma is for ETFs to try and dominate in this space. 

A number are already very liquid and well-diversified. They are already high scrutinised. They are transparent.

Gradually adding esoteric funds into their universe will not put the ESG industry at risk but still provides the opportunity for new managers to succeed. 

An ETF/ESG combination will also make life a little easier for the IFA community struggling with yet another regulatory change. The regulatory changes may prove to be for the best.

Robert Vaudry is managing director at Copia Capital Management