ESG investing is more than a pandemic-driven bubble, but beware of the responsible investing mirage
It’s not news to say that 2020 has been a watershed year for ESG investing. And while the global pandemic has contributed to record-breaking inflows into ESG funds this year (as well as raised concerns of a growing bubble), this is by no means a pandemic-driven bubble. Asset managers were already placing major bets on responsible investing before March lockdowns put ESG further under the microscope.
Recall in early January when Blackrock CEO, Larry Fink, warned CEOs that the climate crisis would fundamentally reshape finance, followed a few days later by Fidelity International CEO, Anne Richards, claiming that active managers, in particular, are best positioned to deliver positive climate outcomes.
And investors responded.
According to recent reports, AUM for funds that incorporate ESG data into their analysis surpassed $40 trillion this year. And a recent report from PWC suggests that ESG funds in Europe could reach 57 percent of total AUM by 2025, up from 15 percent today.
But just as quickly as ESG AUM has risen, so have concerns over lack of clarity on ESG standards and the potential greenwashing of investment funds. Those concerns have triggered calls for a more structured approach to tracking how ESG considerations get integrated and operationalized into the investment process. For more on that topic, view a recent webinar we did with Carmignac Asset Management, MSCI, FS Sustainability, and Shoreline consulting.
At the center of this issue is how to better understand what goes into an ESG rating and how to evaluate fund manager due diligence as they build ESG portfolios. Those issues are merely a new take on the traditional active vs. passive investing debate. And that all boils down to expected investment outcomes.
ESG ratings themselves offer investors a great starting point for measuring companies. The datasets and models upon which ratings are built are becoming more sophisticated. And for investors seeking exposure to companies with certain ESG ratings, there’s nothing at all wrong with investing in a portfolio built entirely on ratings data. That would be a passive ESG investment product, and it should be priced accordingly.
Where investor concerns are rising, however, is with the potential for active managers to market funds as “ESG-integrated” that are actually, more-or-less, portfolios constructed solely based on third-party ratings data. The cynical observer might assume this type of portfolio would be offered by an active manager aiming to eke out higher fees while running a passive product, but in fact, investors also contribute to this dynamic.
It’s not uncommon to have investors ask active managers for the ratings data on ESG funds, then scrutinize the names with lower scores, and pressure managers to tilt portfolios to the ratings. That buyer/manager dynamic can lead to greenwashing, help inflate a bubble, and potentially create systemic issues around ESG investing. That’s why it’s so important for asset managers to be able to have discussions with their investors about their internal approach to ESG investing. That process naturally should use third-party ratings as a starting point, and then it should dig deeper into companies within their portfolios, the ESG-specific purpose of company strategies, and each company's responsibility in achieving their stated purpose.
ESG considerations are highly subjective. They aren’t always black and white, and neither should be the discussions that buyers and sellers have about how ESG portfolios are constructed and managed. But ESG considerations should be substantiated and documented.
A recent report published by Redington, a UK-based investment consultant, highlighted a 16 percentage point gap between managers who claimed to consider climate-related factors (76%) and firms that could provide examples of when climate-linked considerations influenced buying and selling decisions (60%). That kind of disparity doesn’t necessarily mean that additional diligence and analysis didn’t drive those buying and selling decisions. It just means the asset manager couldn’t point to examples of that analysis.
That inability to demonstrate how ESG considerations impacted investment selection and monitoring is one of the reasons we developed — in collaboration with our investment management clients — ESG Scorecards. You can read more about ESG Scorecards here, but it essentially enables active fund managers to integrate their ESG data and proprietary workflows into their broader investment research process so they're able to capture and share how ESG considerations influence buying and selling within client portfolios.
But Scorecards is just one small piece of the ESG investing puzzle. As investor demand and total AUM continue to grow, we’re going to see improvements on all fronts. Ratings will become more sophisticated, standards for measuring impact will mature, and new regulations across all major market regions will drive added transparency. While there will no doubt be challenges for fund buyers and sellers in the short term, you can be sure that ESG and responsible investing is not a short-term bubble; it’s here to stay.