- “Cheap talk” about ESG integration currently outpaces actual use of ESG factors as a basis for investment decisions by a wide margin
- There are frictional reasons that ESG adoption takes time to promulgate through a firm and be put into practice
- There are also numerous technical challenges that make it difficult to implement ESG integration as desired
- But the biggest reason for the gap is fundamental: most fund managers view ESG integration as an externally imposed constraint, not a source of alpha which will enable them to boost performance and draw in more assets
- Unless and until a widespread paradigm shift occurs from constraint to alpha source, genuine ESG integration will remain limited to a minority of mostly SRI-focused funds
Policy vs. Practice
There’s a big difference between having an ESG engagement policy to show to inquiring investors, and making ESG a pillar of an investment process. While it’s not possible to get an exact statistic without being a fly on the wall in fund managers’ offices, it’s clear that the amount of talk about ESG currently outpaces the use of ESG factors as a basis for investment decisions by a wide margin.
Part of the reason for this is that ESG talk is cheap, in the sense that – in the absence of standardized definitions, monitoring and audit capabilities – it’s very difficult to verify a fund manager’s true level of commitment to responsible investing principles. Therefore, managers have a strong incentive to “greenwash” their investors and prospects by churning out progressive-sounding yet non-substantive policies, principles, value statements and case studies.
The majority of this Insight is devoted to describing a more fundamental reason why, at many firms, ESG is struggling to move from marketing and compliance into core portfolio construction. We present two paradigms for thinking about ESG: the “constraint” paradigm, and the “alpha source” paradigm. We reveal how, because most Portfolio Managers still view ESG as a constraint instead of a source of outperformance, they are reluctant to adopt it wholeheartedly.
Barriers to Adoption
In general, ESG faces three categories of barriers to adoption by fund managers: frictional barriers, technical barriers, and philosophical barriers. We discuss each in turn, with a focus on philosophical barriers, since these represent a fundamental obstacle to the promulgation of environmental, social and governance criteria in investment decision making.
Part of the explanation for why ESG practice is lagging policy is just a matter of time: there are frictions related to learning, knowledge transfer and implementation.
At most mid to large-sized asset managers, Portfolio Managers exercise a considerable degree of autonomy over how they structure their investment process. The parent firm may provide various resources – such as help with risk management, proxy voting, and shared research – but PMs have discretion over how and to what extent they use these services.
With the exception of dedicated sustainability or SRI-focused strategies, ESG is generally being implemented at the firm level. That is, policies and capabilities are being developed by a different set of individuals than investment decision makers. This means that it takes time for Portfolio Managers to become aware of the new capabilities, and learn how to apply them to their individual process.
These frictions do not necessarily imply that investment professionals oppose ESG integration. But if a Portfolio Manager has been running a strategy in a particular way for many years which did not separately consider ESG factors, she is unlikely to immediately modify her process to accommodate them. She will first need to get up to speed on the complex ESG landscape and her firm’s approach to it, and then figure out how to incorporate it into her own process. This exercise can take considerable time – but eventually, frictions will dissipate, bringing behavior more closely in line with policy.
Practical obstacles can also prevent implementation of stated ESG approaches. It’s common for ESG integration policies to be vague and aspirational, with little explicit consideration of the potential difficulties in implementing the stated objectives.
Here are some examples of technical barriers that can complicate on-the-ground implementation by Portfolio Managers:
- A policy calls for directly discussing certain issues with a portfolio company’s senior management on a regular basis, but the fund manager is not high-profile enough or a large enough shareholder to obtain access to those executives.
- A policy specifies that ESG issues should be considered in conjunction with other factors when making decisions, but does not provide a meaningful practical framework for making such assessments.
- A policy expresses high-level beliefs about the importance of certain principles, and/or their impact on corporate financial performance and/or investment performance, but does not address how contingencies such as valuation should be taken into account.
- A policy recommends the use of data which is not available or cannot be reliably collected for the investments under consideration, or the use of thresholds with ambiguous definitions (i.e. a restriction on no more than 20% of sales from activities linked to fossil fuels can be calculated in several different ways).
- A firm subscribes to multiple ESG analytics or ratings providers, whose outputs and recommendations conflict with one another.
- A firm sends detailed ESG questionnaires to existing and potential holdings for due diligence purposes. However, a number of them do not respond, while others provide vague, incomplete or uninformative answers.
These types of challenges can cause even the most serious implementation efforts to fall short. When problems such as ESG data availability arise, the fund manager then needs to decide whether to exclude an investment from his universe on that basis, or proceed without the desired information. Oftentimes, excluding the investment will be impractical and potentially irresponsible.
When conducting returns attribution, the Global Investment Performance Standards (GIPS) provide a generally accepted measurement framework that can be audited and verified. But when it comes to measuring ESG performance, investors and fund managers are currently left to create their own measures of whether and how their portfolio is having a positive non-financial impact. The lack of a reliable mechanism to determine the success or failure of an ESG strategy means that for many Portfolio Managers, it can look like an exercise with amorphous benefits but concrete costs.
These technical challenges are likely to be slowly mitigated over the next decade, as standards coalesce and disclosure quality increases. However, overcoming the confusion is not likely to happen in the short term. For example, alongside the ever-growing number of ESG rating services, there are also about 500 rankings, 170 different ESG-related indices, 100+ awards and at least 120 voluntary standards, according to a recent review.
Now to the most serious issue: if Portfolio Managers do not truly believe that ESG integration will translate into better portfolio outcomes, then they will not genuinely embrace it when constructing their portfolios. In fact, it would be irresponsible for them to do so.
A Portfolio Manager’s compensation is usually heavily weighted toward (1) assets under management, and (2) performance versus a benchmark. Therefore, to be incentivized to buy in to ESG, the PM needs to at a minimum believe that doing so will not decrease either of these items. And to really embrace ESG, he needs to believe that it will help him either attract more assets, improve relative performance, or both.
It’s relatively unlikely that an ESG orientation would deter flows into a fund, but a Portfolio Manager might reasonably believe that ESG could harm performance. That leads us to the first paradigm.
There is a truism in optimization problems that it is preferable to have fewer constraints than more constraints. In mathematics speak, any locally convex maximization problem produces a weakly lower value of the objective function when constraints are imposed. Here’s what this means:
Suppose there are 3 stocks available for purchase: A, B and C. One Portfolio Manager is free to pick any of the three stocks to invest in. The second Portfolio Manager can only pick B or C, because stock A is excluded by his ESG screen. Which would you rather be?
Clearly, the first PM can do at least as well as the second, because he’s free to pick all of the same stocks. If stock B or C is most attractive, both PMs will invest in it. In addition, however, PM #1 is also free to pick stock A. In situations when stock A is more attractive, he’ll outperform PM #2, who is excluded from A and forced to pick the second-best choice.
For a real-life example of how this works, note that Norway’s $1 trillion sovereign wealth fund, widely regarded as a leader in sustainable investing, has disclosed that its ethical exclusions have led to an “accumulated underperformance” of 1.3% over the last 13 years, compared with an unrestricted equity benchmark.
Some ESG proponents might argue that even if performance ends up being slightly lower, ethical principles dictate forgoing investments in certain types of companies. That’s a perfectly valid point of view, so long as it conforms to a fund’s IMA. But it’s easy to see why Portfolio Managers who think according to the constraint paradigm, and whose compensation has little to no direct tie to their fund’s ESG credentials, might resist the imposition of ESG screens into their process. The less flexibility they have to invest in the best opportunities available in the market, they the lower their returns may be over time. And that would be a disservice to their clients.
Alpha Source Paradigm
While the constraint logic is prima facie true, there is another line of reasoning that yields a different conclusion. In fact, investors use screens all the time to identify promising securities or firms to invest in, which possess desirable characteristics.
A screen can be a way of filtering through a large opportunity set to distill a smaller opportunity set believed to be of higher potential. Value investors might screen for stocks trading at low earnings multiples and generating strong free cash flow. Private equity firms might screen for stable businesses owned by founders approaching the retirement age. And fund selectors might screen for managers with consistently strong past performance.
If a fund investor believes that ESG performance is positively associated with investment returns (i.e. ESG is a factor which generates positive alpha), then she might embrace the use of an ESG-related vetting process in the same way as any other screen. By constraining her universe to firms aligned with her principles for responsible investment, she is focusing on opportunities which she expects will outperform the broader opportunity set on average. This will lead to higher expected returns than an unconstrained search.
Conclusion: A Matter of Perspective
Even the most enthusiastic ESG proponents currently face real frictional and technical barriers to implementing ESG integration in the way they might be aspire to, or even represent in marketing and due diligence materials. This is part of the reason that ESG integration often falls far short of its potential. These difficulties should be gradually worked through over time.
A more fundamental barrier occurs if the fund manager believes that ESG integration either will not help, or (worse) will hinder, his or her achievement of key objectives such as performance and assets under management: in other words, when a Portfolio Manager has either no incentive or a disincentive to embrace ESG practices.
This fundamental barrier occurs when an individual subscribes to the “constraint” paradigm, as opposed to the “alpha source” paradigm. In the constraint paradigm, ESG is viewed as a compliance or marketing requirement being imposed by outsiders – such as a middle-office department in the firm, or the fund’s investors – which must be overlaid onto the investment process.
In these cases, since ESG is not a new concept and the fund manager was not using this overlay prior to its imposition, clearly he or she had already concluded that it was not part of his or her optimal investment process. Therefore, the requirement is viewed as a check-the-box exercise and not wholeheartedly adopted.
We can safely conclude that ESG-dedicated funds and asset management firms subscribe to the alpha source paradigm (where alpha can be broadly defined). Likewise, fund managers who only adopt ESG when encouraged or forced to by external pressures, despite previously being aware of its existence, would by implication subscribe to the constraint paradigm.
By comparing the (relatively small) number of ESG dedicated funds and fund managers to the (relatively large) number of other managers who are only choosing to focus on ESG integration now that it has become virtually mandatory due to external pressures, we can conclude that the majority of managers subscribe to the constraint paradigm. This is the main reason why genuine ESG integration is so rare, and will remain half-hearted unless and until those managers switch paradigms, or their compensation structures are significantly altered to heavily incentivize ESG performance.
Author Information: Jordan Boslego is a Partner at Empirically.