Competition in the environmental, social and governance sphere is heating up, but the race is not necessarily all about assets. Some ESG investors will only select like-minded managers that focus exclusively on ESG, but relying on subjectivity and emotion may be a mistake.
As the ESG space has burgeoned, propelled by a nitroglycerine-like performance boost during the pandemic, financial advisers and consultants are understandably searching for the best options for their clients.
Assets under management paint a confusing picture as experienced ESG boutiques are rapidly eclipsed by larger rivals, whose gargantuan marketing budgets have helped them hoover up investors’ ethically-focused cash.
So where to turn? Well, it seems that ESG specialisation is the defining characteristic that many believe sorts the wheat from the chaff.
The conviction in this is so strong in some quarters that some fund selectors, advisers and consultants refuse to accept that an asset manager can run traditional investment products alongside ESG offerings, and there is a growing tendency to mark such businesses down in the due diligence process.
Blinkered view
On face value, this might make sense. Why not choose someone whose focus is entirely on one thing, and who is passionate about this area?
The problem here is multi-faceted, but two aspects are particularly important.
Firstly, if a business has always done one thing and one thing only, there is an argument to suggest that they might not be able to see its pitfalls.
ESG is undoubtedly having its moment in the sun, but what does an ESG portfolio actually mean in terms of risk?
Intuitively, the application of filters and the introduction of active share relative to the market portfolio should negatively impact risk/reward characteristics.
A traditional exchange-traded fund portfolio might comprise as many as four times the companies in it than an ESG or socially responsible investment equivalent, meaning investors are increasing their concentration risk, sector skew and geographic concentration.
Lack of objectivity
The other problem relates to the subjective nature of ESG investing. Investors would love to believe that the long-term performance of investing in sustainable companies will be superior to that of the broader market.
The belief is that because the strategy aims to do good ethically speaking, it will also do well financially.
This is attractive as a belief set but is not neatly supported by history. In fact, it is arguable that some sin stocks, notably tobacco, have traditionally produced outsized gains for investors – in tobacco’s case in spite of litigation and rising public awareness about the harm combustible cigarettes cause.
It does not necessarily follow that just because capital moves to sustainable stocks that they will do well ad infinitum and applying an ESG filter to a portfolio is a decision based primarily on conscience and principle, both subjective criteria.
Subjectivity is the prerogative of the investor. Asset managers should surely respect the intentions and preferences of investors, but should objectively apply expertise, science, academic findings and financial objectivity while doing so.
