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ESG: investment research considerations

ESG is now a key part of the investment process for the vast majority of fund management firms.  For some, this has been a natural progression while for others, a great deal of work has been undertaken to embed these factors anew.

Fund research businesses are often called upon to provide their views or to highlight “best in class” funds in this arena.  But perhaps this isn’t as straightforward, or indeed appropriate, a task as it seems.

Baseline ESG considerations in mainstream fund management

Few would refute the concept that the integration of ESG considerations into the mainstream fund management industry is a positive development.  In many cases, the expansion of the ESG section in process and marketing documents has only confirmed a pre-existing reality:  professional investors do not knowingly allocate capital to companies that engage in unethical practices.  Today, enhanced ESG analysis has raised the bar, providing fund managers with a greater understanding of the culture of a company, the standards of its management and the wider impacts of its operations.

Deeper integration of ESG factors in mainstream fund management

The picture becomes more complex when we consider the ways in which ESG issues are interpreted by a firm and/or by individuals within a firm.  For some, basic but non-negotiable ESG standards are in place, to which fund managers must abide.  Over and above the basic thresholds, fund managers may be able to operate with a degree of discretion with regard to the mandates under their responsibility; for example, a particular fund manager may choose to avoid tobacco companies.  Other firms have more highly developed ESG policies, with specialists feeding information into the analytical process.

Such processes are likely to have a more tangible impact upon the investments that are permitted within investment portfolios and hence, a more direct effect upon risk and return outcomes.  More evidence is certainly emerging of fund managers choosing – or being encouraged – to steer away from areas such as traditional energy, alcohol and gambling.  Such decisions are not necessarily a result of overt deselection but may be an acknowledgement that the greater focus upon ESG and tougher regulations could have a direct effect upon a company’s finances and growth profile, hence lessening its investment appeal.

A personal approach

To espouse any preference or produce any grading with regard to the way in which ESG considerations are deployed by fund management companies is fraught with difficulties.  Indeed, it is not clear that we, or our peers, should be the arbiters of taste on these issues.

It should be expected that all retail-facing fund managers will exercise sound judgement and take steps to avoid companies that behave poorly; in other words, they must have a robust baseline ESG policy that underpins the investment approach.  Thereafter, the extent of ESG integration into the decision-making process should be the choice of individual firms and fund managers.

Ultimately, individuals – perhaps with the help of their adviser – must decide for themselves whether a firm’s ESG policies match their personal tastes.  For one person, a baseline policy might be sufficient.  Another might like the idea of company engagement.  Others may wish to go further into the sustainable investment arena, choosing a firm with stricter policies and/or funds with specialised mandates.

Customer outcomes and measuring risk and return

The implementation of different ESG policies has varying impacts upon customer outcomes.  To state the obvious, the stricter the ESG threshold, the more a portfolio is likely to veer away from a recognised index in terms of its composition and characteristics.

By way of example, is Amazon a “good” company, or a “bad” company, or something in between?  What about its carbon footprint?  Does it encourage abject consumerism, or has the company become an important public service, particularly in these times?  And will its Climate Pledge Fund offset its environmental footprint in a meaningful way?  These are all valid questions that will certainly engender a mix of responses.  The recent allegations about poor working conditions in factories producing clothes for Boohoo and others is another pertinent example.  One specialist pointed out that one ESG rating provider rated the company highly, while another ascribed a medium risk assessment.

Suppose a sustainable global fund excludes Amazon on ESG grounds.  As it stands today, this decision would have resulted in an unpleasant dent to a portfolio’s relative performance.  Is this a good customer outcome (following ESG principles) or a bad customer outcome (an opportunity cost that resulted in underperformance)?  This is an impossible question to answer and depends entirely upon your own perspective.

This brings us on to the tricky question of how to measure the risk and return outcomes of funds that follow stricter ESG policies or have outright ethical/environmental mandates.  We disagree with the idea that such portfolios should be judged against standard benchmarks without caveat or explanation.  Fund managers sometimes argue that such portfolios should outperform because sustainable companies will be recognised and rewarded in the markets.  While we can certainly hope that this will be the case, this is an ambitious statement.  Even if we were to accept its validity, over what timescale might this become a reality?  At the least, customers should be made aware of the sector, market cap and style biases that mark out these funds from the chosen comparative index, and what this might mean for the relative risk/return journey, for good and for bad.

In short, we must accept that such funds will deliver idiosyncratic outcomes that are difficult to judge on outcome alone, given the almost limitless nuances that lie beneath.  Indeed, in attempting to judge a performance outcome, we are implicitly judging a fund manager’s chosen ESG screen.  Here, we circle back to one of our original points: who is the arbiter of ESG taste?

A word on corporate engagement

We should be sympathetic to the idea that through corporate engagement, fund managers have the opportunity to encourage an improvement in business practices for the benefit of not only investors, but also for society/the environment more broadly.  Indeed, there is a strong argument in support of so-called “sin” companies remaining in the listed sector in order to facilitate a level of transparency that may be absent if they fall into private hands.  In that sense, it could also be suggested that investment exclusion is not always a positive force.  To our minds, investing in the listed mining company that takes the safety of its workforce seriously and minimises its environmental impact would seem to be a very good idea.  The world still relies upon basic materials, however much some may wish it were not so.

Read more articles like this via our insights page

About the author

Gill Hutchison, Research Director, The Adviser Centre

Gill began her career in 1992 at Credit Suisse Private Banking London and managed a discretionary portfolio of funds service before joining MeesPierson Private Banking as a portfolio manager.  She joined OBSR in 2003 (later acquired by Morningstar) where she had leadership roles in the research team and headed the investment consultancy business.  She founded The Adviser Centre with Peter Toogood in 2014 and the business has been part of the Embark Group since 2016.

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