How to choose an authentic ESG strategy?

How to choose an authentic ESG strategy?

Asset management firms’ main purpose has traditionally been to meet clients’ risk (volatility)-returns objectives. In fact, when I studied for my CFA level 3 exam back in 2002, these were the 2 main objectives of the Investment Policy Statement. Now, almost 20 years later, our industry has evolved and “sustainability” or “ESG” is increasingly becoming part of the investment process or strategy objective. For reasons I will explain below, ESG investing means different things to different people. We would however break it down into 3 main broad categories: risk management, values/impact and alpha opportunities.

In my experience, investors wishing to invest in ESG-dedicated strategies want to go beyond risk-management, they somehow want to do “good” and have a positive impact with their investment. I believe that this is possible (think for example about green energy transition as a future driver of returns). However, selecting strategies that optimise risk and returns together with a ESG objective without falling into the trap of greenwashing is a very tricky task for fund selectors. This is for three main reasons. Firstly, because of human biases. Research[1] from NYU STERN and INSEAD demonstrates that investors have difficulties picking investments that optimise efficiently both return and non-financial (for ex. a social outcome) objectives. Secondly, as reported by Rhodri Preece[2] of CFA Institute, there is a lack of ESG expertise in the investment industry. Thirdly, the industry has invested a significant amount in marketing efforts to make investment strategies “look & feel” ESG. So how to pick ESG authentic strategies?

When assessing ESG authenticity of fund managers I focus on 6 factors (see below). In this short article we will be looking at Factor number 1: The why and what alignment.

Factor 1: Pick mission-driven asset managers

While risk and return objectives are quantitative measures, ESG objectives are different, though, as they are non-financial and largely based on Values. Values are mostly subjective and qualitative. This is reflected by the large divergence between ESG rating providers. In a recent study[3] from the CFA Institute Foundation, its author, Pedro Matos writes that “many ESG factors require subjective decisions”. As such it won’t be until a globally accepted taxonomy will be created, that an objective judgement on what is a sustainable activity can be made.

Therefore, a first step for a credible ESG assessment is to screen and understand the Values transpiring through an investment solution and whether those consistently percolate across the firm and value chain. In our opinion greenwashing arises when a firm is trying to retrofit the organisation with new Values that it deems appetible from a marketing perspective. This experiment is at best difficult and takes us into the sphere of change management and culture.

Mission-driven managers with ESG at their core have a significant advantage here as they are set-up with ESG consideration in their DNA and are therefore more likely to be credible.

Analysing ESG authenticity

Factors

Possible red flags

1.        Why & what alignment

The bigger the size (AuM) and the longer the track-record, the more difficult to change the organisation’s mission

2.        Process

ESG has been included in the process story only recently

3.        Reporting

Limited non-financial outcomes metrics on factsheets

4.        Fund manager ESG track-record

Star fund management approach

5.        ESG Data analysis

High ESG scores does not necessarily reflect high authenticity

6.        Innovation, ESG leadership, industry cooperation & engagement with clients

Limited use of external data, opinion and new technology



[1] “Categorical cognition and outcome efficiency in impact investing decisions”, August 2019. Matthew Lee, Arzi Adbi, Jasjit Singh.

[2] “The sustainability transition has reached a critical moment”, 2021. Rhodri Preece, CFA.

[3] “ESG and responsible institutional investing around the world a critical review”, 2020. Pedro Matos, CFA. Institute Research Foundation.

Fabrizio Palmucci, CFA is a Senior Advisor at the Climate Bonds Initiative and the founder of Impactivise, a consultancy boutique. He has spent close to 20 years in the fixed-income buy-side space in different roles, trading, credit analysis and strategy and with several firms from boutique to tier one assets managers and rating agencies. At the Climate Bonds Initiative, Fabrizio works with issuers, originating banks as well as investors to reduce market friction and improve risk differentiation for green investments.

Contact details: [email protected]  / www.impactivise.com