Why ESG Isn't Working for Investors

What is ESG investing?

Investors have more options and decisions to make around capital allocation than ever before. Increasing geopolitical, social, and cultural factors – as well as pressure to keep up with historical performance and stay ahead of technology trends – create a complex investing environment that is difficult to navigate.

One particular type of fund that’s grown in popularity is ESGs (Environmental, Social, and Governance). Publicly traded companies with provable initiatives that support sustainability, social responsibility, and good corporate governance receive grades or ratings by market data providers like MSCI, Moody’s, Sustainalytics, or CDP, to name a few. These companies are then grouped into a portfolio by asset managers and provided as an ESG fund to investors.

While ESG investing has been available for several decades, it has gained more attention in recent years. Since 2018, the total sustainable investment assets under management have increased 42%. Assets in ESG funds hit a record high of USD 1,258 billion as of the end of September 2020, with Europe surpassing the USD 1 trillion mark.

Environmental

Climate

• Carbon emissions, energy consumption
• Water usage
• Waste and pollution output

Natural Capital

• How are business models aligned with sustainable use of natural resources (air, water, land, forests, etc)
• Biodiversity and ecosystem health
• Community and people impacts where business operates

Social

DE&I / Employee experience

• Actions companies take to build a diverse workforce and gender equity

Human rights

Human capital

Governance

Board quality

• Protecting the interests of stakeholders and economic success of the company
• Election of directors
• Director independence, tenure limits, election cycles, diversity, and time commitment.

Diversity
Strategy, purpose, culture

• Company transparency and disclosures
• Long term financial resilience
• Executive compensation
• Long term strategic plans should be aligned to overall ESG approach

What’s not working about ESG investing today?

Despite this growth and popularity, some serious challenges risk undermining the effectiveness and progress of impact investing.

Trust in Ratings

Key among the challenges is that there is no standardization across reporting from country to country or even between organizations in the same country. In a recent GaiaLens survey, 23 percent of asset owners expressed satisfaction with the quality and consistency of the ESG information they’re receiving. This dissatisfaction is attributed to a lack of clarity, transparency, and robustness in the methodologies used by data providers.

Unequal Distribution

Many asset owners feel there’s too much attention paid to environmental issues (the “E” in ESG) compared to the social and governance factors. While climate change and carbon emissions are critically important, impact investors also care about human rights, employee experience, company culture, and board quality and effectiveness. The factors, in many cases, have been overshadowed but deserve as much attention. Additionally, weighted importance of these factors vary geographically. In Europe, there has been a greater emphasis on decarbonization while in the US, recent cultural events have propelled Diversity, Equity, and Inclusion into the spotlight.

Performance Variability

Professional money managers create specific ESG funds, such as the Pax Large Cap Fund Institutional (PXLIX) or the Thornburg Better World International I (TBWIX). While these funds perform well on a 3-year total return percentile ranking, this is not true for every ESG fund. Performance varies by portfolio mix, active vs passive management, and cost. Investors’ experiences with ESG funds (from a performance standpoint) can vary widely depending on the fund they invest in. This variability in experience has the potential to hurt the ESG brand in the long term.

Misaligned Expectations

Investors' philosophies do not always match the financial services firm or asset manager. For example, many investors see ESG as a social impact tool and are willing to see below market average performance over the short-term in service to impact and mission. Contrarily, other investors view ESG funds as a risk mitigation tool and have a higher tolerance for the types of holding companies in a portfolio. For instance, some asset managers have eschewed defense manufacturers and fossil fuel energy companies from ESG funds in recent months due to Russia’s war in Ukraine and the increasing effects on climate change despite some of their noteworthy social or governance initiatives. When these stocks perform well, investors with outsized capital in these ESG funds miss out on the returns.

How to improve the ESG investing experience?

Creating a Holistic Investing Perspective

Investors typically do not look at ESGs singularly. They view these funds as an important piece of their overall mix of investments. That’s why we should think about improving the ESG investing experience by looking at the holistic investing experience first.

My preferred way to view holistic experiences is by taking the customer or user's point of view first. Then, you build context around it. I would start with these four steps.

1. Understand the customer needs, goals, and “Jobs to be Done.” Build your strategy around solving these areas first.
2. Develop a value proposition that’s supported by customer verbatims and sentiment. Test and revise to hone customer segmentation and the best ways to appeal to them.
3. Create a sustainable measurement and customer engagement plan to evolve offerings based on actual usage.
4. Optimize beyond marketing by extending customer insights to teams leading onboarding and service or support experiences.

Designing Good Services

Asset management companies have an opportunity to help investors make sense of the compounding and conflicting ESG data made available by the range of data service providers. Northern Trust Asset Management has done this with its ESG Vector Score. Through investment and M&A activity, many financial services firms have created their own ESG scoring models. They blend the myriad of quantitative data with qualitative reports and self-reported meeting notes.

As the amount and availability of data grows, these models and methodologies will evolve. Advisors can differentiate by being transparent and having good customer-facing explanations for how they assess companies. Investors must sharpen their analytical and data literacy and build trusting relationships with their advisors. Additionally, advisors should take advantage of the educational gap in the investor community. They can provide simple and clear content that speaks to a range of ESG considerations, including how ratings are generated and how portfolios are constructed.

Good services start with understanding of the holistic customer experience, set clear expectations, and respond to change quickly. But most of all, they enable customers to achieve their desired outcome. Compelling and useful ESG services for investors start with this mindset.