Friday HighlightSep 25 2020

The investment sector needs an ESG standard

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The investment sector needs an ESG standard

Two major investing themes dominate the conversation in the investment management industry these days: passive investing and ESG investing.

Morningstar reports that total assets in passive stock funds eclipsed actively managed funds for the first time in August of 2019. ESG investing is also growing rapidly, comprising about 25 per cent of all funds under professional management, according to various estimates.

Passive investing started to take hold early in my career, and I have watched its inexorable growth with admiration.

As in politics, simple, understandable, and repeatable marketing messaging that is brought to life when certain trends or circumstances capture the popular imagination works just as well in investment management to reach the end audience.

This was a concept well understood – he built an industry powerhouse on it, after all – by the late Jack Bogle.

Passive investing represents an easy concept to understand: the lowest fees, “you own the market,” and a constant and consistent message from its proponents of “over the long term, the vast majority of active managers can’t beat the market.”

Now the industry is faced with a new analysis challenge in the shape of ESG – one that demands higher levels of analysis and rigour than perhaps is required in the realm of passive investing.

Institutional investors are more likely to consider ESG investing as a way to generate higher risk-adjusted returns, while retail investors mainly look to ESG characteristics to express their personal values

So, can ESG investing match the passive investing marketing message? To date, clearly not.

ESG investing has often been defined, not so much by globally accepted and agreed definitions and standards but, to paraphrase a US Supreme Court justice, as “I know it when I see it.”

There is also a lack of agreement on just what is meant by “ESG investing.” Many terms come into play: sustainable investing, impact investing, socially responsible investing, and more.

Many investors think they can “do good” by investing with one of these objectives in mind.

Clearly, the investment industry needs to do more to help explain the landscape to investors and help them understand some critical trade-offs they may be making when investing in products that are labeled ESG.

For many years, most ESG investors only focused on the G: governance. Board composition, executive compensation, poison pills, and the like. Best practices could be fairly well-defined and agreed by most market participants.

The challenges that society faces from climate change and environmental degradation have directed more attention the E: environmental factors. And that gets much more complicated.

While governance issues remain fairly straightforward, embracing environmental factors as a component in fundamental investment analysis muddies the equation.

It is easy enough for an investor to seek to exclude, say, coal stocks when building a portfolio. Negative screening certainly achieves that goal.

But a corporation’s environmental footprint is much more complicated than that.

Determining whether a company in the aggregate is actually helping to improve the environment requires much more complex analyses – as well as having access to the relevant data – than investors realise, or, if one is being cynical, have been led to believe.

And then the S: social. What does that mean in the most basic sense? Does a company treat its employees well? Does it have a positive and respectful culture? Does it embrace a certain set of values? Is the workforce diverse and inclusive? Is the company contributing to societal gains?

Does it embrace a wider set of stakeholders, as the Business Roundtable and World Economic Forum have called for? The list goes on – with no easy or clearly definable answers.

Clearly, ESG investing is a long way from achieving what passive investing has accomplished: basic benchmarks, simple and clear information, standards, understandable terminology. This confuses investors, who increasingly want to know about the impact of their investments.

The soon-to-be published CFA Institute 2020 Investor Trust Study found that that while 19 per cent of institutional investors and 10 per cent of retail investors currently invest in products that incorporate ESG factors, 76 per cent of institutional investors and 69 per cent of retail investors have interest in ESG investing.

Institutional investors are more likely to consider ESG investing as a way to generate higher risk-adjusted returns, while retail investors mainly look to ESG characteristics to express their personal values.   

Cyrus Taraporevala, chief executive of State Street Global Advisors, asserted at the Financial Times’ Future of Asset Management summit in 2019 that one day a company’s ESG rating will be as important as its credit rating.

But now, for any investor seeking to both earn a return and to be a force for positive change, the investment choices are confusing and seemingly infinite -- and the metrics for judging impact are not well developed.

We at CFA Institute hope to do our part. As the global leader in standards for the investment management profession, we are in the process of developing an ESG investment product standard that will build a framework for investment managers to better communicate, and for clients to better understand, the nature and characteristics of ESG investment products.

We believe such a standard can protect against “greenwashing” in the same way our Global Investment Performance Standards protects against “cherry-picking” investment returns: that is, give investors standardized information for transparency and comparability so that clients can make more informed choices.

We seek to build a classification standard so that clients can easily identify products with similar features.

We want to build a common language around features, so that clients can understand what they are getting in a specific product and give them the ability to make comparisons between products.

And we will strive to specify the information that should be disclosed if a feature is offered so that clients can fully evaluate if the product meets their requirements.

This potential standard will not solve all of the challenges around ESG reporting and investing. But we think a new ESG investment product standard in investment management could be a start.

Margaret Franklin is president and CEO of CFA Institute