Q&A from a talk at Cambridge’s Venture Cafe on “ESG and Technology”
I spoke last week at Cambridge’s Venture Cafe on “ESG and Technology.” This post is a summary of that talk.
We’re interested in this topic because, from the beginning, our rebalancing software has supported automated implementation of ESG screens. This made it incrementally free to offer ESG constraints to clients. That removed one barrier to use, and it resulted in all of our clients increasing their use of ESG. But it is clear from the experience of our clients that more is needed to expand ESG usage than simple operational simplicity. There needs to be a story of how ESG investing interacts with “normal investing.” This has been a slower evolution. In our talk, and in the post below, we cover everything from the basics of “what is ESG investing” to the deeper question of how ESG investing gets folded into standard investing practice.
Q: What is ESG investing?
A: ESG stands for “environment, social and governance.” There are three types: social screening, social impact, and social activism.
- Social Screening
Social screening (more precisely, negative social screening) seeks to eliminate companies with poor ESG records from an investor’s portfolio. The canonical example is “I don’t want to own tobacco stocks.”
- Social Impact Investing
Social impact investing (also called positive social screening) seeks to preferentially invest in companies whose businesses will have a positive impact on the world in a specific way. For those interested in the environment, an example might be investing in a wind-powered electric generation company. The idea is to make money, but do good at the same time.
- Social Activism
Social activism investing seeks to leverage one’s status as a shareholder to pressure companies to change — to make both bad companies and good companies better than they were before.
Q: Does ESG investing affect returns?
A: I think it’s worth noting that the point of ESG investing is not positive investment outcomes, per se. It’s possible that companies with positive ESG attributes will outperform, but if that’s the motivation for applying ESG principles, it’s not really ESG investing — it’s just an investment strategy.
That being said, the record on whether ESG investing is good or bad for returns is unclear. Roughly speaking, it seems to be the same as non-ESG investing. I think this is sort of what one would expect based on a simple (probably too simple) model of how the market works: if ESG investing was notably better, non-ESG investors would buy enough ESG companies to drive prices up, thereby eliminating any forward-looking advantage (assuming company earnings were unaffected by its stock price). And if ESG investing were notably worse, you’d see this work in reverse, with non-ESG investors selling ESG companies to drive prices down, thereby eliminating any forward-looking disadvantage.
Q: How common is ESG investing?
A: Globally, 26% of professionally managed assets have ESG parameters, with about 21% in the US and over 50% in Europe. So ESG investing is not a fringe concept.
At present, these assets are mostly owned by institutional investors, not individuals, but we can attest from our own experience that the importance of ESG investing is increasing among advisors serving individual investors. This is partly just because the percentage of investors who are interested in ESG is growing. It’s also because when investors do ask for ESG constraints, it is often a make-or-break issue: the investor will walk away if the advisor cannot accommodate their wishes.
Q: What’s the primary motivation for ESG investing? Does it change company behavior?
A: For most people, there is a fairly straightforward moral imperative with ESG — they view it as immoral to be a part-owner of, say, a tobacco company. And this preference holds regardless of whether their non-ownership changes the behavior of any tobacco company.
But it’s still reasonable to ask: does ESG investing change company behavior? Does it change the outside world in any way?
The record is mixed. Social activism — exercising one’s rights as a shareholder to vote, submit resolutions, etc. — obviously has the potential to change company behavior if the number of ESG-minded shareholders is large enough. And it doesn’t always require a majority to make a difference. Given that institutional investors own lots of shares and a large percentage exercise ESG principles, getting a hard-to-ignore group of shareholders to support ESG initiatives is not out of the question.
But with social impact investing and social screening (tilting portfolios towards or against certain types of companies), whether there will be an impact on company behavior is muddled. At a theoretical level, the main problem is that you would expect non-ESG investors to balance things out. If, for example, the boycott of tobacco stocks by ESG investors actually managed to bring tobacco stock prices down, then, assuming tobacco company operations weren’t affected, tobacco stock yields would go up and non-ESG investors would have an incentive to buy more, cancelling out the effect of the ESG screening.
A similar (though slightly less strong) argument applies in reverse for social impact (positive screen) investing when the purchases are made in the open market (i.e. you’re just buying from another investor). If the investment is in private capital or an IPO (in which case the money goes directly to the company you’re trying to help), it’s more plausible that the investment is helping the company. One argument in the other direction is that executives at negatively screened companies argue against being excluded and executives at positively screened companies tout their ESG bona fides. So apparently, they — believe it’s important.
Q: What’s the easiest way to implement ESG investing?
A: The easiest way is through purchasing ESG mutual funds and ETFs. There are a lot of choices, and the list is growing.1
But there are some interesting alternatives, as well:
- Do-it-yourself-screening tools: these systems hallow advisors and investors to apply positive and negative ESG screens to help select the stocks in their portfolios. However, screening can get pretty subtle. For example, if just 1% of your revenue comes from tobacco sales, are you a tobacco company? 0.1% of revenue? And what if you manufacture cigarette rolling machines? Are you a tobacco company? There’s no single right answer.
- Automated “robo SMA” rebalancing systems: automated rebalancing systems have made it easy for advisors to manage customized SMAs, including the option to apply ESG screens. With the right automated rebalancing technology, you can reduce the incremental cost of customization to zero.
- Direct indexes (where investors own a representative subset of a broad index): direct indexes are especially suitable for ESG screening. The reason for this is that securities within a direct index are held not for their individual merit, but because of their statistical properties — there’s not a strong reason to prefer Chevron over Exxon. And that makes it easier to exclude certain stocks without having any effect on the quality of the portfolio.
Q: How does ESG investing fit in with “normal” investing?
A: It think this may be the big issue with ESG investing. The industry still hasn’t quite figured out how to seamlessly incorporate ESG investing into “normal” investing. For advisors, the main focus of portfolio management is to balance risk and expected returns in a way that suits each client’s needs. How, exactly, does ESG investing fit into this? Social screens (positive or negative) reduce the set of stocks that can be included in a client’s portfolio. This can result in poor diversification, which increases risk. That goes counter to the demands of ordinary portfolio management principles. Is it OK to increase portfolio risk to implement ESG constraints? What about a small amount of additional risk? And if that’s OK, what counts as “small”?
At an abstract level, the (slightly boring) answer is presumably that there needs to be a balance between the two ESG preferences and standard investment criteria. If ESG constraints reduce your buy list to two stocks, you’ve got a problem. But some additional risk is OK. No one would think twice about investors who wanted to use some of their wealth to fund a charitable cause. Why shouldn’t incurring a bit more risk to apply ESG investing principles be just as normal?
That being said, there are no commonly accepted principles for deciding what level of negative investment impact is too much. In spirit, firms could control the negative risk effects of ESG investing the same way they control risk when they’re overweighting securities with higher expected returns. Typically, this is done by setting diversification guidelines and/or setting limits on maximum expected tracking error relative to some benchmark. It would be easy enough to apply this to ESG investing, as well. But we’ve never seen a firm actually implement this as a policy. This may be because most advisors lack the tools to appropriately measure the risk impact of ESG investing, which puts them in a tough spot. Fortunately, this is, in theory at least, easily fixed. The technology exists to provide advisors with real time feedback on the risk consequences of any ESG decision.
Q: A final question: where do you think ESG investing is headed?
A: I can talk a little bit about our own experience working with advisory firms buying rebalancing technology. ESG screening functionality used to be something of an afterthought. No more. ESG is now a short-list concern for virtually every firm we speak with. In part, we think this is part of a larger trend among advisory firms to turn away from product-oriented and performance-oriented value propositions. In its place, firms are emphasizing helping clients meet their goals — whether financial or ESG related. Instead of ESG investing and “normal” investing being compartmentalized, we’re seeing ESG investing becoming part of the norm.
For more on this topic, check out ESGs: An Ugly Duckling no More.