Sustainable Finance: Cheap at Twice the Price?
The European Commission’s long-awaited legislative proposals on sustainable finance, released 24 May 2018, seek to position the EU and its investment management industry at the forefront of sustainable investing. The proposals are part of a broader political strategy by the EC to take the global lead on the COP 21 climate change agenda while other nations are distracted by various domestic and geopolitical issues. Although the implementation of the General Data Protection Regulation (GDPR) in May has made Europe a de facto global standard-setter for data protection, it remains to be seen whether these sustainable finance proposals will have a similar reach.
Increasingly, Environmental, Social, and Governance (ESG) investing is becoming mostly environmental investing, with a bit of social on the side. The EC’s use of the phrase “sustainable finance” reflects this reality, as do the proposals in the package, which mostly revolve around climate change risks. The proposals would mandate disclosure of sustainability risks from market participants across the investment chain, ensure instruments in client portfolios are based on client ESG preferences, and introduce an EU-wide mandatory taxonomy of environmentally sustainable economic activities.
Talking to investment management professionals around the world, two core narratives can be distilled regarding ESG investing. The first narrative is that ESG investing is being increasingly demanded by clients, particularly institutions such as endowments, that are looking for their investments to achieve a positive social impact. No doubt some are interested in simply minimising the risk of being publicly shamed for having undesirable investments. This is certainly believable and in line with the general mood of the times — formerly private opinions and affiliations on a wide range of issues are becoming increasingly public and increasingly important in determining social status for both persons and corporations.
The other narrative is that ESG investing provides better performance. As someone who supports improving E, S, and G, this narrative rings a few alarm bells — if evaluating ESG factors in the investment decision process provides better performance, why weren’t the managers doing this anyway? From my years in finance graduate school, I remember the Fama and French Three Factor Model’s size- and value-factors being widely known and debated, but no one ever discussed ESG factors!
Perhaps, like the three-factor model, the ESG factor approach simply needed time to be discovered, and we are now living through that time. However, the amount of data-mining finance Ph.D. students perform in the pursuit of a factor model that would get them a Tier 1 publication makes it surprising that it has taken this long to discover the importance of ESG factors. Others argue that ESG factors are better interpreted as a re-discovery of value investing by a generation of managers that can no longer rely on classic portfolio-theory derived short-term strategies to satisfy their search for yield.
Be that as it may, it would seem that every portfolio should now be an ESG portfolio since investors presumably want the best performance available, particularly if it also lets them feel good! An article by John Authers in the Financial Times suggests a provocative alternative motivation for the ESG push:
On the side of the devil, ESG offers a rebranding for an unpopular industry, an excuse for data providers to crunch a lot of data and then charge for it, a great opportunity to bid for the huge pools of money held on behalf of public sector workers and charitable organisations that tend to be politically liberal, and most of all, an opportunity for active management to justify its existence in comparison to passive managers.
A strong case can be made that ESG investing is a worthwhile exercise for certain investors even at some detriment to performance, after all many parameters can enter an investors’ utility function. However, the rising narrative that ESG investing offers better performance seems too good to be true and may prove a source of embarrassment in the future.
This latter point sets up probably the most controversial part of discussions around sustainable investing — whether and to what extent it should be part of fiduciary duty. Particularly, do clients’ ESG preferences override the manager’s fiduciary duty regarding suitability and return maximisation? Anecdotal evidence on this topic suggests wide regional differences in opinions between Europe, the United States, and the Asia Pacific region. To further investigate these attitudes, CFA Institute will soon be launching a member survey, so stay tuned.
Photo Credit: ©Getty Images/Towfiqu Photography