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.
ESG represents the most pivotal restructuring of the investment process since the development of modern portfolio theory, securities analysis and the concept of “shareholder value”. Yet, even in the face of this massive change, most managers have not altered their research valuation/budget processes, which are poorly adapted to the more complex, less homogenous set of ESG inputs and providers. Failure to adequately budget and value ESG inputs creates headline and regulatory risks associated with greenwashing.
Many new processes are evolving to address ESG requirements. These include the proliferation of ESG/climate databases (140 and counting), the development of complex ESG taxonomies, hybrid accounting structures, various ESG organizations and standard-setters, increasing regulation and even the integration of ESG criteria into corporate executive compensation structures.
ESG has added a new dimension to the measurement of investment returns – one that is extremely challenging to model by conventional means.
To be credible and competitive, ESG fund products must articulate their investment/ESG objectives and the process by which they are achieved. However, most managers have not altered their research valuation/budget processes, which were designed for the previous environment. This is a particular issue for the thousands of conventional funds which have “re-branded” into ESG products.
The counting of interactions or documents provides zero basis for establishing the value of an ESG database to an Impact Fund. True ESG integration requires a completely new approach.
In the ESG landscape a more complex, less homogenous set of inputs and providers, including ESG databases, specialist data (climate etc.), thematic research and proxy advisors, are required to service a wide variety of funds with very different objectives.
Within the ESG category itself, increasing complexity will require the differentiated application of ESG and fundamental inputs. It seems unlikely that the following types of ESG funds would use identical inputs.
Source: Global Impact Investing Network
Given the diversity of these fund objectives, clearly no one singular ESG data score can describe how any given company would be assessed against all of these objectives. Although all the categories above are classed as “ESG” funds, the investment processes of these vehicles will be far more varied that those of fundamental equity funds, style differences notwithstanding.
The managers of each strategy should be able to clearly articulate the security selection and portfolio construction process and well as the external information inputs that inform the strategy. (This is particularly important in the US under 28(e) as asset owners are paying for those external inputs.) It should be a concern to fund investors and consultants (let alone regulators) if the manager is unclear as to what inputs are required to execute the ESG strategy.
The growth of ESG, is, by definition, creating greater asset owner/regulator scrutiny at the fund level. Regulators in the EU, the UK and the US are all emphasizing fund-level ESG attribution to avoid greenwashing or fund descriptions that may be misleading to investors.
Even in the EU, under SFDR, Article 6, 8 & 9 funds are likely to use ESG inputs to varying degrees. Article 6 funds are only required to consider ESG risks as part of the normal portfolio risk process, rather than having specific ESG objectives, and are therefore likely to use fewer ESG inputs versus Article 8 or 9 funds for which ESG outcomes is central to the investment strategy.
ESG/Fundamental Fund Matrix
Much of the growth of ESG funds, particularly in Europe, has come from “re-branding” funds as ESG offerings. In fact, the vast majority of today’s ESG products began life as conventional fundamental funds. The chart below from Morningstar indicates the sheer scale of this very rapid transition.
Do the ~5,000 newly re-branded “ESG” funds still use a research valuation/budgeting process designed for the 2-dimensional world used by their predecessors? If so, how much have they really changed? These funds likely have the greatest burden of proof related to potential greenwashing. All of this should lead to greater scrutiny at the ESG fund level. Yet ironically, this is where even the most advanced ESG managers frequently struggle to allocate ESG inputs.
While there is increasing clarity of ESG inputs at the firm and security levels, input allocation at the fund level remains opaque.
The longer that asset managers allow ESG and fundamental research valuation/budgeting processes to remain in separate silos, the greater the risk that the manager may be accused of overstating the degree of ESG integration at the fund level.
This is precisely the complaint the SEC and the US Department of Justice are investigating related to DWS, a large European asset manager. The impact of the investigation has been material. The share price of the manager dropped 15% on the announcement last August wiping € 1.5 billion from its market cap. The stock has not recovered subsequently.
But, the risks go beyond regulation. The mere suggestion of greenwashing can be very damaging to carefully and expensively constructed ESG franchises. Despite the immense investment many managers have made in their ESG products, many have neglected to construct the “last mile” of transparently allocating ESG inputs at the fund level which will certainly be subject to increasing scrutiny. This is a completely avoidable risk.
ESG funds need both ESG and fundamental research inputs. It’s not possible to run a portfolio based on climate data alone. Managers that can demonstrate the transparent allocation of ESG and fundamental inputs at the fund level will have more competitive and sustainable products. The responsibility lies with senior management. ESG departments have their own priorities and may not have the enterprise-wide remit to make these decisions. Managers should ensure that their ESG fund business models are resilient and sustainable as their ESG funds claim to be.
European managers have enjoyed a first mover advantage, capturing the lion’s share of 3rd party ESG funds flow – thus far. But, sustainability is a long-term game and the playing field is about to change.
In the US, the Biden administration vows to end Trump-era rules prohibiting pension trustees from considering ESG factors in asset allocation/manager selection. The US Department of Labor is expected to issue new ESG-friendly guidelines later this year which will be a catalyst for potentially huge investment in ESG strategies by US pension funds, who heretofore felt legally constrained by the existing rules. This may level the playing field for US managers who also enjoy long-term funding advantages – if they can credibly integrate ESG and fundamental inputs at the fund level. Further insights are available at: https://www.frostconsulting.co.uk/esg-research-valuation-framework