As ESG funds continue to attract record flows, the debate as to whether these strategies should outperform has gained increased attention. However, according to Alex Rowe, lead portfolio manager of the Nomura Global Sustainable Equity fund, this debate is far too one dimensional from an investment perspective, and more importantly, it completely misses much of the point behind the rise in ESG investing.
In 2020, ESG funds featured prominently in the headlines following very strong performance, and proponents pointed to this outperformance as the first big test for many of these strategies as evidence of their strong alpha potential.
During the first months of this year, many of these strategies lagged behind considerably as market conditions changed and certain styles – most notably growth – suffered and headlines emerged that ESG funds were now set to give back their previous outperformance.
An argument also started to gain traction that, over the long term, underperformance should be expected, as ‘good ESG’ will naturally lower the cost of capital and expected returns.
This assumes that ‘good ESG’ has been priced in and herein lies just one of the issues we take with this debate.
ESG or sustainability is inherently highly subjective.
While a number of considerations are deeply consensual – anyone would agree that slave labour or fraudulent activities are clearly immoral/unethical – many other aspects are more subjective, and opinions can vary widely.
Our definition of ‘sustainable’ is companies that have a high total positive impact, balanced fairly across all stakeholders.
For example, certain pharmaceutical companies’ drugs and treatments have a positive impact on human life and the efforts taken to ensure access is very important. However, it is also crucial to examine rigorously the issues and controversies related to industry practices such as pricing. Other market participants that focus purely on the investment materiality (ie the potential impact on financial returns) of ESG, apply greater weight to the risk that comes with operating in a sector that is prone to litigation, and tend to award lower ESG scores. Companies with very low emissions or environmental impact as a result of their business models are often deemed very strong with regards to environmental considerations.
One can argue, however, that there are companies with somewhat higher operational emissions, but their products and innovations will be the solutions enabling the transition to a low carbon economy, are truly more sustainable. The latter tend to have lower scores with some ESG research providers and will contribute to higher portfolio emissions but, in reality, they can play a much more important role in averting a climate crisis.
If we take a cursory look over the holdings of the 800 new sustainable funds launched last year, we can appreciate the huge variance in interpretation of ‘sustainable’. Investors must combine their ESG views with their investment styles.
Any assessment of whether ESG funds have outperformed or whether they should outperform is therefore very likely to be based on a highly heterogeneous and poorly defined sample set.
Another key point this debate often fails to account for is what is priced in by the market. A company that is positively aligned with climate megatrends and manages the climate impact of its operations diligently will experience greater tailwinds operationally than a company that is far behind the curve. Conversely, that does not necessarily mean that an investment in the former will generate better returns – it ultimately depends on the price paid. Should ‘good ESG’ not be appropriately priced in, we would agree that an investment has the potential to outperform. However, should these ESG credentials or opportunities have attracted so much attention, that valuation becomes entirely detached from fundamentals, this would not make for an attractive long-term investment. Simply put, ESG is just one of multiple, interlinked considerations and assessing it in isolation as a driver of return is overly simplistic.
Finally, and perhaps most importantly, the debate misses much of the point of ESG.
Returns and performance are at the heart of everything we do as investors, but what is expected of the industry has changed.
The understanding of the impact we have on the environment and broader society – and therefore the responsibility to act positively in these areas – is growing rapidly. Over the years, our understanding of the environmental and social crises unfolding around us, and the focus on our own personal impact, has increased exponentially. Investor surveys suggest the most popular reasons for interest in sustainable investing are in relation to taking responsibility for the impact of investments, rather than return considerations.
Given the magnitude of the issue facing our world today, the most pressing debates we should be having are those addressing the role of the industry in tackling these challenges and how it can evolve to achieve attainable solutions to meet the ever-increasing demands from our clients for investment solutions that truly have a positive impact on our world.