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How ESG Are You, Really?

Until the industry adopts standard metrics for ESG investing, only customization and transparent communication and disclosures will help these strategies fulfill their promise to investors.
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When I was a portfolio manager, performance reporting was a key part of my marketing message. With strategies that often ranked within the top 10 in their category—not percent, mind you, but top 10 within the strategy—communications with investors, consultants, advisors and prospects were simple. Why wouldn’t you invest in our strategies? They’re among the best. That’s not my opinion. It’s an objective fact.

Asset managers are graded daily on a wide variety of characteristics—returns, yields, performance versus benchmark or competitive group, volatility, Sharpe ratio, beta versus benchmark ... the list goes on.

Now we are adopting another set of very important metrics, environmental, social or governance (ESG) indicators—and the more nebulous concept of “impact.” Still, there’s no widely accepted metric for ESG, despite the explosive growth in investor interest in the strategies, from institutional portfolios to retail investors and ETFs.

A 2020 survey from Barclays found that $100 billion had flooded into ESG-focused products from 2018 to 2020. The COVID-19 crisis only accelerated the trend, as sustainable funds attracted record levels of cash. As the millennial generation ages into prime investing and savings years (and inherits the largest amount of wealth in history), the demand for funds that do well and do good (the concept of multiple bottom-line investing) can be expected to increase. Let’s not forget the UN’s 17 Sustainable Development Goals as guidelines for global development.

So, we need a process and an agreed upon methodology with accepted measures to find out how much good these investments do in clear, transparent and concrete terms, and make them literally just as easy as checking performance data.

Not that market participants aren’t trying. Fitch, S&P and Bloomberg all have ESG stock ratings, which measure ESG performance according to a range of indicators, from tracking carbon emissions to measuring board and workforce diversity. But these ratings all require judgement calls. Which indicators should you follow? How much weight do you give to each, and why?

Moreover, companies, like human beings, are often a complicated mix of good and bad. What do you do about a company like Coca Cola, which does great work on diversity and inclusion but contributes to a global epidemic of obesity and diabetes?  

How do you handle good companies in historically bad industries like mining? Do you care that one company has reduced waste and pollution by half, when its entire industry is engulfed in abusive labor practices, corruption and environmental damage?

And, of course, because these ratings are calculated on a stock-by-stock basis, the process of integrating and tracking them at the portfolio level is, to say the least, complicated.

At the portfolio level, tools for measuring ESG performance have also begun to emerge. In 2016, Morningstar launched its five-globe Morningstar Sustainability ratings, which provided a rough guide to ESG characteristics of over 20,000 mutual funds and ETFs, updated monthly. But the ratings are something of a black box. We don’t know exactly which factors are used and how they’re weighted.

In addition, because ESG is values-based, it’s hard to comprehend and even more challenging to calculate if a highly rated fund aligns with a specific investor’s values, which may diverge sharply from the values Morningstar’s model emphasizes. And finally, neither Morningstar nor any other ESG rating service has emerged as a dominant player. There’s no industry-wide agreement on how to rate and compare the ESG characteristics of strategies or funds.

There’s a lot of potential to measure impact investments by the specific impact key performance indicators that the product lists in its investment strategy. Wouldn’t it be great to know that Fund X reduces carbon emission by this many tons per year, while Fund Y does only half that? But so far, these kinds of tools are in their infancy. To the extent they exist at all, they’re ad hoc, and their details are not generally accessible to institutions and their consultants, let alone to financial advisors or the investing public.

In short, we need an industry standard measurement that will allow people to say ‘this fund is more ESG than that fund,’ or even, ‘this fund has a better environmental impact than that fund.’ Until then, we have crude tools, good intentions and a lot of investors who would like more specific, granular information.

Yet even this evolving situation provides opportunities for asset managers who can demonstrate their commitment to sound ESG practices. Communicating what you’re doing to fulfill ESG requirements and how you assess, track and measure ESG compliance and results can become a powerful marketing tool, if done correctly.

My team had the experience and ESG-affinity to assist in explaining to clients a strategies methodology and ESG performance in lieu of an industry standard benchmark. And we are hopeful for smart-beta ESG funds and all the tilts that the more thoughtful part of the passive universe can conjure and deploy.

Someday, demonstrating ESG impact will be as simple and as commonplace as stating correlations. Until then, only customized processes and the right messaging can answer the question “How ESG are you?”

Andrew Corn is the CEO of E5A Integrated Marketing, a data-driven agency that assists investment firms with raising assets or capital.

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