It is hard to avoid the debate on environmental, social and governance (ESG) investing. It is even harder to challenge politically correct attitudes on this subject – but here goes.
The roots of today’s ESG debate lie in the US in the 1950s, when pension funds first realised they could use their growing capital base to effect social change. From these small beginnings, progress was very slow and very patchy, however.
In the 1980s I managed segregated mandates with ‘socially responsible’ constraints for institutional clients. You would be given a customised mandate and benchmark with guidelines adapted to exclude certain investments – typically tobacco companies, arms manufacturers, gambling businesses and South African entities.
This was fine, as institutional clients always had the right to give you customised guidelines and benchmarks. And it worked for two key reasons: it was the client’s choice, not ours – the manager was not imposing his own ethics, and performance measurement was not prejudiced. And the investment objective was paramount to our maintaining the mandate and benchmarks were adjusted accordingly, so the performance discussion was not compromised.
This form of mandate was not called anything particular, and such clients were few. It certainly was not thought of as a ‘product’. As the years went by, this type of thinking began to be labelled ‘socially responsible investing’ (SRI) and started to receive more coverage. Around the turn of the century, marketing guys became interested in SRI and demand pull became supply push.
But it is one thing to respond to market demands for ethical investing and quite another to tell the market what it is and embed it in products.
There is no standard understanding of what ESG should look like – ethical priorities are not the same. Customising a mandate for one client’s preferences or biases is fine. Creating a product for mass marketing is another.
What should be included and why? Who are you ignoring and who are you offending? This always created tensions between managers and marketers – the former want as few restrictions as possible, while the latter want to be as inclusive as possible to expand potential sales.
In my view, it is very difficult for product manufacturers to be prescriptive about what the right ethics are and I am not sure it is their job. Nor can I see why they are in the best position to set the standard for what constitutes responsible behaviour.
Confusion is created by this dual mandate – do people invest to meet an investment objective or do they invest to change the world for the better? Give one up and the discussion between manager and client is straightforward. Include both and the debate becomes highly compromised.
A manager defending his disappointing returns to his client because of the restrictions on the investment universe is not a relationship that lasts very long.
The debate has, of course, become more sophisticated over time, although the problem remains the same – can investment objectives and financial needs sit happily alongside ethical imperatives?
A few years back, the debate began to change from ‘ethical investing is good for your soul’ to ‘ethical investing can be good for your wallet’. Analysis was developed to support the thesis that investing in ESG-type mandates would lead to superior performance over other mandates as companies would benefit from consumer and capital investment demand for ESG activities, such as water and renewables. This tried to resolve the dual mandate issue by saying the investment criteria was paramount and social and consumer trends were being exploited.
This is what I call the ‘positive’ case for ESG – it is good for your wallet and therefore will appeal to both ESG-conscious clients and those not so concerned by these issues. The performance proof to back this up is, in my view, still outstanding, although it should not be discounted. It is little different from saying that emerging markets or small cap are good sectors to invest in for certain structural or economic reasons.
Even here, however, it is important to be as specific as possible in order not to compromise performance measurement. For example, limit as much as possible the manager’s discretion in their investment process and stock selection to decide what is ESG; and make the investment universe as specific as possible, such as water or renewables, rather than ‘environment’.
Straight to the top
The ‘negative’ case for ESG – the mandate needs to exclude those things that are bad for the planet for ethical reasons – is the area which is most troubled. Whose ethics are the right ones? Where is the limit? And what if performance sucks? The manager is in a very tough or arguably impossible place if it tries to prescribe the ethics and says performance be damned.
From the perspective of ESG-sensitive clients, it may be better to campaign directly for corporates to implement ESG in their conduct rather than indirectly through asset management mandates and products.
After all, there is a growing body of literature supporting the view that firms that adopt ESG in their best practices improve their bottom line. This is likely to be a more sustainable and rewarding way of influencing change than outsourcing it to investment managers and trying to embed it into products.