One pint of ESG -aligned return please
Forcing an assortment of bonds, equities, property and private market opportunities into an environmental, social and governance (ESG) aligned investment template is proving to be more difficult than initially thought. It turns out that fund managers, and the advisers that market their wares, still have a long way to go before they figure out which tap to pull when a clients asks: one pint of ESG-aligned return please.
ESG does not sustainability make
“The big mistake the world has made is believing that investing in ESG equals investing in a sustainable future: it does not,” said Anne Cabot-Alletzhauser, Practice Director for the Responsible Finance Initiative at GIBS Business School, during a no-holds-barred commentary on ESG investing practices and outcomes. Her 40-minute-long presentation to the 2022 Old Mutual Wealth Advice Forum explored the relationship between client, financial adviser and fund manager as each contemplated the best way to allocate capital for impact and sustainability.
“Your clients want to know that their money is being deployed in a way that will not just bring them return, but also improve the world that they live in; stakeholders across the asset management value chain have realised that they must start integrating social and environmental factors alongside the purely financial,” she said. The easy part of the discussion was handled within 60 seconds; but things became more technical over the ensuing 39 minutes, with many furrowed brows in the audience. The real debate started with the observation that a high sustainability rating was not an accurate measure of a fund’s impact.
This observation was backed up by reflecting on a flow-of-funds study conducted by Morningstar around 2016, and dubbed by the presenter as “the curious case of Morningstar’s sustainability ratings”. This study highlighted the fact that when Morningstar added sustainability ratings to their existing fund assessments, there was a dramatic surge in the flow of funds towards those funds with high sustainability ratings and away from funds with low sustainability ratings. The puzzling part was highlighted in a follow-up study five years later: contrary to investor expectations, these funds did not out-perform. In hindsight, the answer as to why this was the case is obvious.
Sustainability ratings a poor starting point
“When we measure fund performance on purely financial terms, we expect to see an improvement in performance from the start of our investment to the end … when you are using service-provider data to measure a fund’s ‘sustainability’ or effectively its ESG rating, and you start with highly rated funds, the chances are that that information is already reflected in the value of the fund, Cabot-Alletzhauser explained. “Much of the assessment data used in ESG and sustainability ratings is backward-looking; more importantly though, most of this data does not reflect an improvement in a company’s rating from one year to the next”.
Since asset managers typically want to invest in something that is going to improve and create value over time, it is antithetical to use high sustainability ratings as a starting point for investing. This leads us back to Cabot-Alletzhauser’s most important point: Funds that have high ESG ratings do not necessarily translate into ‘sustainable’ investments, i.e. funds that will be able to change the world. She makes the point that international organisations such as the UNPRI or those that promote alignment to net-zero carbon emissions have only recently come to understand that translating ESG into sustainable outcomes can only be achieved through completely rethinking portfolio construction.
Challenging the status quo
Against this backdrop, some have started challenging the asset management industry’s obsession with impact and sustainability, saying: the only thing more dangerous than no progress, is the illusion of progress and accusing the industry of selling an illusion. The problem, it seems, is not with the investment principles nor what clients want, but rather with how fund managers are integrating sustainability into their methodologies. Can investing in ESG make an impact? Yes it can; but for asset managers to demonstrate that they are achieving this for their clients the industry will require a complete cultural shift in the way it manages money:
- It will need dynamic benchmarks that are able to capture the improvement required in whatever it is you want to measure.
- It will need better data that captures not just what a company intends to do, but whether they have achieved their strategic goals around ESG.
- It will need reporting standards that highlight not just the financial performance of a fund, but whether the companies in that fund were able to meet their sustainability targets.
- It will need an independent vetting and verification facility to protect clients against greenwashing or the risk that a the marketing promise being made on the fund is not achievable given the fund’s structure.
Simple solutions to a complex problem
We drew the following five conclusions from Cabot-Alletzhauser’s presentations, though we could not hope to summarise all of the points made:
- We must appreciate that we are asking asset and fund managers to do something they have never done before, because to solve for sustainability requires them to tackle and understand complex issues like climate change, development theory and inequality.
- We must understand that a good ESG scores does not translate into a good sustainability performance. This should be obvious given the number of providers offering ESG scores, with correlations as low as 66% between two measures of the same construct. “If your ratings are only looking at what impacts on the company, and not at how the company is impacting the world around it, you are going to miss that whole perspective,” noted Cabot-Alletzhauser.
- We must be cognisant that ESG ratings, especially when presented as an aggregate over a portfolio or fund, can be manipulated. For example, a portfolio manager could bulk up on IT shares and disinvest from resource shares, achieving a better ESG rating without influencing any change.
- Know that buying and selling listed shares or secondary market assets will not change anything, nor will proxy voting. Impact is generated by participating in primary issuances and by having real influence in the companies you invest in, through shareholder coalitions and stewardship.
- Certain ESG outcomes might require cultural, regulatory and systemic changes. In other words, it might be impossible to achieve certain impact or sustainability outcomes within funds that are benchmarked against indices, or limited by regulation to asset classes or types of financial instrument, or have to match client assets and liabilities, or have to accommodate clients’ risk appetites etc.
Some solace for financial advisers
“Asset management may still have some way to go before BREAK it can solve for global warming and world peace, but that does not mean we are not heading in the right direction,” said Cabot-Alletzhauser. “In truth, we have always been remiss to think that financial gains are not inextricably linked to social and environmental impact and we need to start incorporating that thinking into our investing no matter what outcome we are looking for”. For now though, as a financial adviser, your biggest job is to manage your client’s expectations.
Cabot-Alletzhauser pointed out that greenwashing occurred when advisers or fund managers failed to deliver on something they had promised to the client, whether it be at the corporate strategy level, the corporate product level or the investment fund level. “There are still ways to invest to take your clients in the right direction, as long as you position the expectations properly; as such, you need to understand what your clients are looking for and match that to a product that has a high probability of delivering on that,” she said. It is also important to know what your client wants to achieve with his or her investment, as well as what they are prepared to “give up” in return for what they think is the right thing to do.
As for the bigger picture: “Clients need to be patient and the investment community needs to be far more pro-active,” concluded Cabot-Alletzhauser. “This is a dynamic process that we cannot afford to screw up, because the world needs this … the environmental and social challenges we face are real”.
Writer’s thoughts:
An evaluation of funds mid-June 2022 points to a mismatch between funds’ environmental, social and governance (ESG) ratings and the impact the components in these funds have on the environment and society. Are you concerned that you cannot achieve the impact and sustainability outcomes your clients expect by simply picking high ESG- or sustainability-rated funds? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.
