Do fund managers need to consider ESG when investing?
ESG is merely one of many factors that might influence whether an investment is attractive, writes UNSW Business School's Mark Humphery-Jenner
Fund managers are often hit with a barrage of ESG information. The media is full of articles about the latest impact-related trend. However, fund managers often only have a mandate to maximise risk-adjusted returns, or to beat a benchmark.
This then begs the question: can and should fund managers consider ESG factors?
The general principle: what should fund managers do?
The answer is surprisingly simple: fund managers should do their job. For a fund manager, the investment memorandum – or the contract with your investors – tells you exactly what you need to do. If the investment memorandum tells you to hit impact targets, do so. If the investment memorandum is silent on ESG, then ESG is simply one factor that may (but need not) influence investment cash flows and risks.
ESG-related factors can be relevant. “ESG” is a broad term that means different things to different people, and to different ratings agencies. The constituent factors may, but need not, impact firms’ risk and returns. To the extent that they influence investment fundamentals, ESG factors can be relevant if they can be modeled in an analytically honest manner.
There is an important caveat, however: As a fund manager, you ought not impose your personal views onto your clients. You are not at liberty to tell your clients what to care about. They have already told you when they invested their money subject to a specific contract.
An implication is then that you should not lie to your clients. Do not lie about whether you do (or do not) consider ESG factors. Do not lie about whether you impose your beliefs about ‘social’ or ‘environmental’ impact onto the portfolio. Do not lie about how ESG factors influence returns. Do not greenwash. This is all the more important since people appear to like the positive emotions of having a “positive” impact, but appear bad at valuing how much that impact costs. All these lies are clear breaches of fiduciary duties to clients.
Using ESG information has its own challenges
The more complex question is then: how does ESG influence risks and returns? There are some general principles.
E, S, and G are different: We should get this out of the way: ESG is vague. Environmental, social and governance factors are entirely different and focus on different factors. Indeed, good corporate governance involves complying with directors' duties, which requires directors to maximise shareholder wealth. But, what is deemed to be good from an environmental or social perspective may – but need not – maximise shareholder wealth. It is important to not bury nuance within a nebulous index.
Constrained portfolios are bad, unless your clients tell you to make one: It is mathematically impossible for a constrained portfolio to outperform an unconstrained portfolio, in general. This is because an unconstrained portfolio can consider the full investment universe. A constrained one cannot. Thus, it ignores ‘good’ investments that are outside the constraint.
A basic example illustrates the point: suppose you constrain your portfolio to only include companies with blue logos. If blue-logoed firms always had a better risk-return profile, they would always have been selected for the unconstrained portfolio. But, if even one red logo firm is better, then the constrained portfolio will underperform.
This analogy applies mutatis mutandis to ESG. If all ‘good ESG’ companies perform better, they will automatically end up in an unconstrained portfolio. But, if even one ‘sin’ company is good, the unconstrained portfolio will outperform the constrained one.
Constrained portfolios can have advantages in some specific situations. This is mainly in unlisted markets where being a specialist fund can improve deal flow or can better enable deep specific knowledge. In this case, a cleantech fund might have an advantage when investing in renewables. But, this advantage is not automatic and must be clearly articulated to clients.
ESG indexes: We can then consider whether investors should rely on ESG indexes. In short, these indexes have major problems. They lump together three quite different pillars: “E”, “S”, and “G” into one index, even if these pillars point in opposite directions.
There are also myriad ESG indexes. They have relatively low correlation and differ significantly both in what they measure and how they measure it.
There is nothing inherently wrong with different indexes capturing different things. The problem is when those indexes purport to capture the same thing but do not actually do so. A firm that ranks well in Refinitiv might rank badly in KLD. This creates a clear issue: which index do you use? Do you use a combination of them? If so, how do you weight them?
This becomes even more of an issue when you consider the relationship between ESG indexes and returns. ESG indexes are negatively related to returns, especially when those ESG scores are more certain (i.e., there is less disagreement amongst indexes). Thus, even if ESG indexes do agree, it is not obvious that a better ESG score necessarily implies better returns.
What then to do about ESG?
The implication is that portfolio managers should treat ESG considerations much like any other consideration. ESG indexes provide a useful list of factors to consider. Some of these factors might influence risk and returns. Some might not. Thus, consider how a factor influences the firm’s cash flows and its risk. Do this in a rigorous, specific, and quantifiable manner.
Bad ESG practices can harm returns or increase risk. They might make customers less willing to buy goods, risk regulatory ire or government intervention, or chance violating regulations. Bad practices might deter lenders or make it harder to raise equity. Whether these downsides are realistic depends on the firm’s specific situation and requires modeling, not hand waving.
It is important to analyse firms on a case-by-case basis, rather than making generalisations or assumptions. Relying on broad ESG indexes, or imposing portfolio constraints, risks making assumptions about how impact-related practices influence cash flows and returns. And those assumptions appear not to be well supported in the literature.
This all boils down the basic principle: Fund managers and analysts should do their job, comply with their investment mandate, and not lie to investors when doing so. If the job is to achieve a specific ESG objective, then invest to that objective. But, if it is simply to maximise ‘performance’, then ESG is merely one factor that might influence whether an investment is attractive.
Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals, and his research interests include corporate finance, venture capital and law. For more information, please contact A/Prof. Humphery-Jenner directly.