December 07 2023

ESG is Dead, Long Live Sustainability

From a practitioner’s viewpoint, I never really had much traction from clients on ESG products. Because it is taking the problem upside down. As a fiduciary, you listen to your clients concerns, investment goals, life projects and respond with an investment allocation that best serves their interest.

Does a one-size-fits all ESG fund serves my clients’ best interest? I don’t know. But what I can tell you what does: selecting an array of companies, or funds that would likely outperform, in a framework that matches their risk profile and objectives.

The last question I want to ask my investors is “what is your view on sustainability?”. However, in my due diligence, I want to make sure I select investments that make the right choices to be performing for the next 50 years. So, I want to be invested in the right company, seizing the right opportunities, on a planet that still exists.

Good companies make money for the long-term. Sustainability has to go hand-in-hand with long-term financial returns.

ESG served its purpose. It was key to set global metrics behind carbon footprint, diversity, equity & inclusion, and governance in order to measure the long-term impact of our companies worldwide. Flows to the ESG theme ramped up at a rate of $150bn+ intake per quarter from late 2020 to 4Q21.

The point that was left wanting was whether instilling responsibility towards long-term social and environmental issues was ultimately going to satisfy the industry’s appetite for short-term returns. This point is still being debated, but public policies on infrastructure, carbon emissions, social equity will undoubtedly make it converge toward that goal.

After years of resounding success, ESG was pilloried for being “woke”, “anti-fossil fuel”, and worst sin of all for an investment, “underperforming”. While Europe flows into ESG have held steady, US investors pulled out.

So, where did ESG got side-tracked?

This noble goal collided with (a) too much hype, (b) a trend toward shot-termism in measuring investment performance, (c) the debate between passive and active management, and (c) the question of who carries the moral responsibility of an investment.

First, the hype.

ESG responded to the investors’ thirst for meaning on the back of very real existential challenges: global warming, north-south bipolarization, and social equity. It provided a very comprehensive framework to measure corporate long-term impact.

Cashing in on this powerful trend, some asset managers were quick to transform what was meant to be “a tool” into a “theme”. ESG funds were born. Strong marketing claims came next on “investing for good”, “shunting fossil fuels”, “calling out unequal governance”.

Such hype was turbo-boosted by the democratization brought about by ETFs, and their main cheerleaders Blackrock, Vanguard, and State Street, who control ~20% of most US large companies.

It didn’t take long for companies falling out of the ESG framework to call it unfair, and return fire, claiming “greenwashing”, and “managers pushing their own social agenda”. The paradox of some ESG exclusions came to the fore, when the world desperately needed fossil fuels as the war with Russia threatened energy supplies, only to realize that years of ESG-led under-investment into the “theme” were now biting hard.

Secondly, short-term benefits VS long-term returns.

Is short-term profit best for my clients? Surely it doesn’t hurt, as long as it doesn’t impede the company’s long term economic potential.

To be absolutely honest, Berkshire Hathaway aside, fund managers’ performance is usually judged on an annual basis, at best. A single year of underperformance invariably results in assets withdrawals. After several lean years for proponents of “active” mandates, hedge funds continued to underperform indices in 2023 so far.

As of Nov23, HFRX (Hedge Fund Research index), which tracks the global performance of hedge funds, reported a 2.58% Year-to-date performance for its Equity Hedge Index. This offers a pale comparison to S&P500’s 20.75%, Core Europe’s 13.51%, or even EM’s 6.32%.

Many hedge funds closed their doors in 2023 as a result. Indexed strategies on Tech and the “Magnificent 7” reign supreme (again). The lure to passively follow trend, such as ESG or Tech is strong, insofar as they attract boat-loads of AUMs in their wake. Such “hit-themes” are hard to resist for asset managers in search of asset growth toward critical size.

Does it mean that active management is dead? Far from it.

 

Thirdly, the debate between active and passive investment management.

Let me open up with a quote from Spiderman “With great power comes great responsibility” – Uncle Ben. Well, large ETF powerhouses learned it the hard way. They collectively thought the ESG framework had enfranchised them to guide “passive” investors. They were wrong. Only the investor herself or its fiduciary knows it.

If in doubt, go back to the bottom line: your clients’ best interest i.e. maximizing their returns, while serving their long-term objective. To me, there are 3 layers to this cake:

1 – the portfolio allocation that corresponds to the investor’s long-term objectives, and there is ground for staying the course i.e. being rather “passive”,

2 – having the responsibility of the underlying investment choices as a fiduciary, and having a very “active” analysis to know what you hold at all times, and

3 – “active” governance, reflecting the end investor’s long term choices by voting them, either via proxy voting or entrusting an intermediary manager to do so.

If in this process, you rely on third parties, e.g. fund vehicles managers, they should engage actively with the companies on issues that are fundamental for their long-term prosperity. And, this is the hardest part that needs to be worked on.

The dialogue should go on. Guiding where the world goes, should always be a matter for debate.

 

Lastly, should investing be moral or ethical? Who’s there to judge? A tough one.

As a species, humans are more preoccupied by living the next day as opposed to make it to the next 10 years. This is where subsistence can clash with morality. Doing well with doing right.

The initial sin of ESG was to try to define what a “good company” was, colliding with the instinctively-preferred measure of the financial industry i.e. short-term profit.

Decisions are hard when they argue between subsistence and morality. Take this Defense company that manufactured the weapon that killed you son-in-law in the latest school shooting, but is also producing the missiles that keeps your country’s enemies at bay. What do you do as an investor, under-weight the stock?

Inevitably, politics jumped into such cleaving debate, and the social responsibility question got muddied between “anti-woke” or “pro-ESG”. It was never meant to be the point, but hey we are all on a quest for meaning.

Bottom line is, we’ll survive as a species if we favor our most likely long-term good.

The ESG tooling will leave a legacy framework to analyze companies’ impact beyond their short-term ability to generate shareholder returns. I fundamentally believe in the role of fiduciary investment advisors to nudge their clients toward making the right investment choices. They are best placed to know and represent their clients concerns, and they are entrusted with a mission to do good. They are the closest thing we have to the guardians of the temple.

I’ll end with key takeaways from a podcast by Capital Allocator between Ted Seides and Carol Geremia, head of distribution at MFS Investment Management in Dec22. I think it represents best where the asset management industry should be guided next.

“ESG will go away, it will not be an investment term in 3 years”.

“We’re redefining active management […] I need to know what I own […] I need to engage with businesses”.

“We’re witnessing the limitations of passive capital […] right now is not the time to follow the herd […] People don’t pay us to be late”.

“If you’re holding a security, you’re holding for a long time, you have to care about a lot of risks and [changes down the line to face environment and social issues]”.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments