The following is a guest article by Neil Scarth, Principal of Frost Consulting (http://www.frostconsulting.co.uk/) which provides customizable research budgeting/valuation frameworks and research spending databases.
August 26, 2021, the day US and German regulators revealed they were investigating allegations that DWS had overstated the ESG integration of its funds, was a milestone for the ESG fund industry. DWS stock fell ~15% wiping €1.2 billion from the market cap and has not meaningfully recovered since. The Financial Times referred to the possibility of “mis-selling”, a serious charge in the UK which has cost UK banks billions in fines.
The trans-national nature of the regulatory scrutiny was also noteworthy. The US investigation of DWS illustrated that the SEC’s new ESG Enforcement Task Force was more than cosmetic. (Interestingly the German regulator only commenced its probe into DWS, a German domiciled manager, after the SEC launched theirs.) Shortly before the DWS news broke, UK regulators had written to all UK asset managers urging them to insure that ESG fund products were “adequately resourced”.
For managers, the hyper-growth of the ESG fund sector must be balanced against the higher costs of running these products and the increased regulatory risks. The winners in this lucrative race will be those that can concretely demonstrate that ESG inputs (of various kinds) are truly integrated into products at the fund level.
This is a natural part of the sector’s maturation process. The chart to the left, from a BNP Paribas survey, shows the changing priorities of asset owners as they allocate to ESG funds. In 2017 the most important factor in ESG manager selection was a compelling ESG “mission statement”. Subsequently, fund performance and reporting became greater priorities.
The next major selection criteria will be the manager’s ability to demonstrate that ESG inputs are truly integrated into the fund’s investment/ research process. Given the societal importance of ESG objectives and their prioritization by most G7 governments, regulatory scrutiny of ESG funds will certainly increase.
There are three key priorities for asset managers running ESG funds:
- Controlling spiralling ESG costs, including data and stewardship.
- Demonstrating the integration of fundamental and ESG inputs at the fund level.
- Ensuring that the quantum and integration of ESG inputs is appropriate for the fund product, as these can differ significantly between funds.
The breadth of fund objectives and the diversity of ESG inputs applied to them is illustrated below:
This is a challenge that few managers, even those with long-standing and sophisticated ESG processes, have mastered. It requires managers to value and allocate inputs including ESG databases and proxy advisor information which don’t conform to the valuation methodologies used for fundamental research, such as counting interactions. And different types of funds (Article 6, Articles 8 & 9), require different types of inputs in different quantities.
Asset managers need to demonstrate to asset owners/regulators that the manager’s ESG products have sufficient and appropriate inputs, while addressing cross-subsidization issues. Based on historic work done with CFA UK, the CFA Institute and Stanford University, Frost Consulting has developed a framework for valuing and allocating ESG inputs at the fund level while integrating them with fundamental research.
It is important to benchmark ESG inputs as part of any valuation process. Once benchmarked, ESG inputs can be used as an overlay to the existing fundamental research valuation process. Frost’s ESG input benchmarking data, together with our ESG input allocation matrix, act as an overlay to the existing fundamental research valuation/budgeting process to demonstrate that funds are getting appropriate resources without cross-subsidization.
Whatever process asset managers adopt, it should bring managers “full circle” by adding the valuation, benchmarking and reporting needed to accelerate their ESG product launches and development – across asset classes.
Managers that can meet this challenge and demonstrate true ESG integration to asset owners/consultants will be well-positioned to capture the growth offered by the ESG category. Further insights are available at: https://www.frostconsulting.co.uk/esg-research-valuation-framework