Environmental, social and governance (ESG) investing has survived a challenging year, with increased regulatory scrutiny and rocky performance providing fodder for fierce debate. While the turmoil that comes with rapid change can be unsettling, we welcome it as a sign that responsible investing is growing up.
In fact, we’ve witnessed this natural phase during previous paradigm shifts in systems, processes and cultures. Within our own industry, we saw a similarly turgid period with the rapid rise of the ETF, which eventually settled into the mature market it is today.
We have found it more fruitful to engage on big ideas early and constructively, rather than ignore them. Thus, we see recent challenges as opportunities for stakeholders to collectively write the playbook for ESG investing: developing and adhering to regulations; settling on a common taxonomy and terminology; and creating diverse ESG-focused return streams that enhance long-term return potential.
Regulators Take Aim at Greenwashing
The questions being asked about ESG investing are serious. Amid the fervor around responsible investing in recent years, investment managers were incentivized to create ESG funds or transition existing portfolios into ESG-friendly iterations. Issuers also stepped up to tout their ESG benefits. Of course, many managers and issuers were genuine. But it was easy for some managers to tout ESG “integration”—a term that could be loosely interpreted. And it was just as easy to overstate responsible capabilities and credentials.
Not anymore. Since 2021, we’ve seen a surge in regulations designed to combat greenwashing and intended to help consumers navigate an increasingly complex investment-product landscape. For managers, it can be challenging to comply with the varying disclosure and reporting requirements of different regions and countries. But at the end of the day, these regulations have a common goal: asset managers should do what they say they’re doing—and be fully transparent about it. That means they must clearly state their ESG objectives, develop and disclose rigorous, dependable investment frameworks that support those objectives, and report comprehensively to clients on progress in meeting those objectives.
Stakeholders Must Speak the Same Language
The wave of regulation and heightened investor awareness demand clear definitions and transparent disclosure. Asset owners and managers must work with regulators and policymakers to help address ambiguity and confusion in defining ESG integration and other responsible investing practices.
First, we must distinguish between ESG-integrated strategies and ESG-focused strategies. Integrating ESG involves identifying financially material ESG issues and then researching and assessing their impact on business and financial measures, such as revenues, margins, cash flows, valuations and cost of capital. Investors must then determine whether the associated risks and opportunities have been priced into the issuer’s valuation.
ESG-focused strategies go beyond ESG integration: they have specific ESG goals or themes, such as focusing on issuers with improving ESG practices or investing in companies that are providing climate solutions, in addition to optimizing risk and return. Regulators aim to organize the varying approaches to ESG-focused strategies—exclusion, best-of-breed tilting, thematic investing, sustainable investing and impact investing, for example—into a common taxonomy.
Investors seeking ESG-integrated portfolios deserve to know how that integration is executed. We believe that ESG-integrated portfolios should take a rigorous approach to documenting how ESG issues are considered at each applicable step of the investment process. For strategies that integrate ESG, investment teams may begin by identifying and assessing material ESG risks and opportunities to help generate investment ideas. Then, analysts should be equipped with proprietary and third-party tools, data and research that enable them to develop a broader understanding of the ESG risk characteristics—and opportunities—of an issuer, sector or portfolio.
To do this effectively, portfolio teams must be immersed in the ESG issues that will define our world’s future from multiple perspectives. Analysts should meet frequently with leaders of public and private companies and noncorporate entities to discuss specific ESG issues. Based on insights from these meetings, investment teams should incorporate ESG factors into their investment decision-making process when warranted by adjusting cash flow discount rates, credit rating forecasts or other relevant metrics.
And true ESG integration doesn’t stop after an investment decision is made. Managers should continue to monitor issuers and work with regulators and policymakers to help address ambiguity in defining ESG integration.
Moving Beyond Controversy
This more comprehensive evaluation of potential investment risks and returns sharpens a manager’s view on the financial prospects for any security. Fundamentally, integrating ESG considerations into the investment process is about improving risk assessment in the expectation of generating improved risk-adjusted returns.
For example, if a portfolio is considering investing in an industrial company whose factories emit a lot of carbon, what will it mean for the business and the return to investors? The investment team must research and consider the impact on the company of potential carbon taxes or pollution regulation on future capital expenditure requirements, or the market share impact of a competitor developing a lower-carbon substitute.
We see ESG integration simply as better-informed investing. However, while few investors would oppose ESG-integrated strategies, not everyone shares the desire for ESG-focused strategies. And just as investors don’t have to own every style box, they don’t need to own every—or any—segment of the ESG-focused investment spectrum.
Demand Will Rise for Diverse ESG Return Streams
Investors who are considering ESG-focused strategies want to be sure they won’t sacrifice return potential. Indeed, the historical link between ESG investing and alpha generation is relatively short and has been spotty.
ESG-themed portfolios generally outperformed the broader market in recent years, especially as many were overweight large-cap growth stocks. But in 2022, as tech stocks slumped and fossil fuels rallied, many ESG portfolios underperformed.
To us, this indicates the need to develop complementary ESG strategies that don’t rely on any single source of beta. As with any asset allocation, investors should consider a variety of equity styles, alternatives and fixed income to diversify ESG-focused return streams. Further, investors shouldn’t be limited to investing in companies, when sovereign debt and real and securitized assets can also pull ESG levers.
Next Steps as Responsible Investing Matures
Responsible investing may have had a challenging year, but it isn’t going away. On the contrary, with net zero commitments driving rapid projected growth in ESG assets and shareholder activism around ESG expected to soar, investors will need increased guidance and clarity around these growing pains.
Amid shifting regulations, consumer preferences and competitive landscapes, asset managers must continue to engage constructively in conversations around ideas fundamental to responsible investing: regulations, common parlance, robust frameworks, differentiated return streams and more.
From climate change to forced labor to discrimination and diversity, ESG factors represent material investment risks and opportunities that can inhibit or encourage the creation of long-term shareholder value. That’s why we believe that the best antidote to ESG challenges—and the best way to secure our clients’ long-term success—is a thoughtful, financial materiality–based approach to investing.