Though ESG has dominated the financial headlines of late, the ESG product deluge has just begun. At US$35 trillion, ESG already represents one-third of global assets under management, according to Bloomberg Intelligence, with more than 40% growth projected through 2025.
But if investors believe they’re fixing global warming and inequality by buying ESG funds, there is a problem.
Maximizing risk-adjusted returns is a popular investment objective because it’s easy to understand, benchmark and explain. ESG targets lack similar clarity. Is the aim to reduce greenhouse-gas emissions, provide more opportunities for women and minorities, fund life’s financial goals or something else?
ESG demand has led to “greenwashing” — deceptive marketing to appear ESG-aware. Inconsistent data and lack of transparency have contributed to the problem, which is a growing concern for securities regulators.
Worse, as former BlackRock CIO for sustainable investing Tariq Fancy wrote in a widely read essay last year, ESG investing may be like offering wheatgrass to a cancer patient: a “deadly distraction” from serious problems.
Most ESG methodologies have no impact on the problems they purport to solve, Fancy argued. Divestment and engagement don’t lead to effective change; ESG-screened portfolios only defer society’s hard choices into the future. Fancy said regulations such as carbon taxes are required for progress to be made.
Divestment vs. engagement
Ranking or excluding companies based on ESG exposures, while popular today, started with religious organizations avoiding so-called “sin” stocks: liquor, tobacco, weapons and gaming. Unlike boycotts of South African wine, however, no direct economic pressure is applied and any potential influence through proxy voting is lost.
Divestment changes ownership but valuations and access to capital are functions of the market, where value hunters and private funding are always present. The result may be that divestment does more in terms of virtue signalling than investing impact.
It can also be costly for portfolios. While hundreds of institutions have committed to divesting some or all of their fossil fuel investments, the implications for portfolios — particularly in Canada, where oil and gas make up 13% of the S&P/TSX Composite index — can be significant when prices for those commodities rise, as they have over the past two years.
Shareholder voting has more potential than divestment to effect change, although cause and effect is difficult to prove. Despite Fancy’s skepticism, collective engagement allows shareholders a voice at the table.
Index fund giants BlackRock, Vanguard and State Street have become active shareholders that may influence governance issues such as board diversity and board independence, but fundamentally changing a business requires confrontation from activist shareholders. That’s what happened last year when activist investors Engine No.1 and Third Point LLC forced Exxon Mobil and Royal Dutch Shell, respectively, to address climate issues.
Investment teams rationally see environmental factors as tangible business risks, but timing is difficult. Higher energy prices help fossil fuel companies in the near term and make alternative energy more viable long term. The challenge is determining appropriate discount rates.
ESG investors should aim for broad market performance at the lowest cost possible. Despite reports about ESG funds outperforming regular funds during the tech-driven pandemic rebound in equity markets, ESG outperformance is far from a sure thing and likely isn’t sustainable.
Most clients don’t want their ESG beliefs to compromise investment performance. Popular ESG approaches don’t directly solve the world’s problems, but they profit less from socially detrimental sectors. Advisors should select the passive manager with the strongest engagement policy.
One measure of a fund manager’s ESG commitment is proxy voting. Most managers default to recommendations by proxy advisory firms Institutional Shareholder Services and Glass Lewis, which consult with public companies about their votes.
The percentage of votes against management or abstentions are indications that an asset manager is reading and considering the proxy material. Analysis from 2019 votes (published in AE March 2020) shows BMO was most active among major Canadian ETF providers.
Engagement and regulation have the best chances to effect change. The risk with engagement is that the largest managers dictate the agendas while profiting from higher-fee ESG products. The risk with regulation is that nothing will happen, and this is the most inconvenient truth of all.
Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.