Edward Glyn reflects on challenges and opportunities for asset managers arising from the growing investor appetite for ESG investments.
There’s no doubt ESG is one of the most significant forces in the asset management industry today. Having been a niche sector for the past couple of decades, with many names and iterations, ESG investing has rapidly moved mainstream in recent years.
Globally, ESG funds saw inflows of more than US$70 billion in Q2 2020, according to Morningstar, driving total assets under management to a record level of US$1 trillion. Calastone’s Fund Flow Index, which tracks monthly net inflows and outflows for the vast majority of UK-based open-ended investment funds, reflects surging UK investor demand. In the 31 months up to July 2017, only £107 million was invested net in ethical funds, but in the 33 months after July 2017 (up to April 2020), the total volume of trading increased to £16.5 billion, with the vast majority of trading stemming from buying activity. Net fund inflows jumped to £3.9 billion, 37x greater than net inflows to July 2017.
A new dawn?
Despite accelerating supply and demand for ESG-based funds, many questions remain about the rationale, impact and processes of using environmental, social and governance factors to arrive at investment decisions. Is ESG investing a new dawn or a recognition of existing, albeit underutilised, best practices? What’s driving demand and are we really making a difference? Is it realistic to try to save the planet and improve society at large at the same time as saving for your retirement? Is it possible to build scalable ESG-based solutions when everyone’s idea of an ethical investment is subjective? Answers are needed if asset management firms are to maintain trusted long-term relationships with retail and institutional customers who increasingly see ESG not just as a priority but as a pre-requisite.
In our webinar – “Entering the ethical investment revolution: preparing for societal upheaval” – our panel of experts argued for the permanence of shift to ESG investing. They also stressed the importance of using ESG-based inputs to reduce investors’ exposure to a variety of risk factors, regarding it as a distinct activity from simply allocating capital to projects and activities with specific real-world outcomes.
Leon Kamhi, Head of Responsibility at Federated Hermes, said ESG investing should be understood primarily as the integration of material ESG risks into the investment process. “Look at what’s relevant. Conduct is relevant at a bank. Carbon emissions is relevant at a utility company. Data privacy is relevant in a technology company. Take those issues and make sure they are properly considered in the investment decision,” he said.
Leon regards the stewardship role of the asset manager as a related but separate aspect of the relationship between investor and issuer: “Be a supporter and encourager of boards to do the right thing by their stakeholders, which leads to their company being more sustainable. This covers strategy, capital allocation, even investor relations, anything that aligns the company more to the investors’ interests.”
He pointed out that funds across the ESG universe can have different methods and purposes. “ESG covers both risk and impact: you can have a positive environmental outcome as well as mitigating environmental risks. But there are also impact funds, which are very focused on delivering outcomes,” said Leon.
“It’s not about tree-hugging”
Already the ESG investing market is a diverse and vibrant place, serving a variety of needs and objectives. Even to experienced investors this can be confusing. Once, ‘ethical’ investments meant only avoiding certain sectors, so-called ‘sin’ stocks. Many of these still exist, but the universe has changed.
Whilst many may feel drawn to ESG investments by vague and subjective ideas about doing good at the same time as earning a return, panellists suggested that ESG investing was helping investors to be increasingly precise and targeted about investment objectives. “ESG isn’t about saving the world. It’s not about tree-hugging and doing the right thing,” said Stephanie Lipman, ESG Analyst, La Française Asset Management, insisting that neither asset managers nor regulators are in the business of making moral judgements.
“No regulator has said you can’t invest in tobacco or alcohol,” she observed. “Regulation is helping to unpick what is a perfectly acceptable investment preference from what could be helpful in propelling us as a society into a more sustainable future, and therefore the companies we invest into have more sustainable performance and returns over the long term.”
Stephanie approaches ESG investing from the perspective of dual materiality. “When I look at a company, I’m looking at the impact of ESG risks – for example, if the company is a high CO2 emitter, what are the future financial and reputational risks from incoming regulation? – but also the company’s own impact on climate change,” she explained.
But what real-world impact is ESG investing really having? Stephanie admitted it can be very difficult to isolate and attribute the direct impact of investors’ policies or preferences on a company’s activities, even through direct engagement and stewardship.
Many paths to positive impact
The plethora of recent ESG fund launches has fuelled debate on which types of fund offer the best outcomes, for investors and the planet. Initially seen as an opportunity for differentiation for actively-managed funds, the ESG space has seen a marked increase in the number of passive vehicles as well, notably exchange traded funds.
“I’d like to move away from the idea that engagement is always good and capital allocation is always less powerful,” said Alex Edmans, Professor of Finance at the London Business School and Academic Director of the Centre for Corporate Governance. “It’s important for investors to recognise that it’s not their job to solve all the problems of every company, but to focus on the type of engagement in which they have most expertise. A passive fund is spread too thinly to get into the weeds of any individual company’s strategy, so specialised engagement won’t work for them, but generalised engagement – voting policies aimed at moving toward more independent boards – is something they can do.”
And despite the arguments that rage about whether it is better to disinvest from a firm which does not address its ESG risks or to continue to work constructively to win management round, Alex sees a case for both sides.
“People often argue that an investor that sells out of a stock is being short term. If you sell because a firm has missed its quarterly earnings target, that’s not good, but you might sell, even if the stock is delivering high long-term earnings, if you don’t believe it’s investing enough in the future,” he said. “You’d like to engage at first. But if engagement isn’t working, perhaps because of management intransigence, to sell is a legitimate course of action.”
No easy answers
Many claim ESG is well on its way to becoming the new normal, with environmental, social and governance factors woven into investment processes as a matter of course. We at Calastone will continue to follow developments closely and will return to related themes in future webinars. But it is clear that there are no easy answers to all our questions at this stage. We will see more fund launches, more data and more regulations, but when will we have more clarity?
“It’s going to get more confusing before it gets better,” admitted Stephanie. “In 12 months, we’ll have seen increased interest, media buzz and hopefully flows, but we won’t yet have reached the point of understanding what is and isn’t ESG. But we’ll be getting there.” Watch this space.