People matter, the planet matters, but so, too, do investor returns.
To many, the consideration of environmental, social, and governance (ESG) issues is at odds with the notion of profit maximization. However, these objectives need not be conflicting. In fact, much of the philosophy that underlies free markets, such as Adam Smith’s The Wealth of Nations, is deeply rooted in moral and social philosophy concerned with the common good and achieving outcomes that are in the best interest of society. (Adam Smith’s earlier 1759 treatise, A Theory of Moral Sentiments, contained the philosophical foundations for The Wealth of Nations.) There are objectives that can and should be considered in addition to—and not in replacement of—the focus on maximizing the bottom line.
True opportunity lies in harnessing the power of the free market to drive positive real-world change.
While it remains important for the very “visible” hand of governments to continue to advance ESG initiatives through a variety of regulatory frameworks, the true opportunity lies in harnessing the power of the free market to drive positive real-world change. In this context, effective ESG investing can be understood as the act of guiding the “invisible hand” toward the efficient allocation of capital to advance investor requirements across a spectrum of values.
An indication of investor desire to consider both financial and nonfinancial objectives can be seen in the notable and increasing demand for responsible investing strategies. According to Morningstar Inc., flows into sustainable open-end mutual funds and ETFs during 2019 and 2020 were $72.5 billion—seven times the cumulative flows in the previous two years and three times the cumulative flows over the previous 10 years. It is clear that investors are increasingly putting their money where their hearts are, by investing in funds that offer to deliver returns and have a positive impact on our world.
Curiously, these asset flows have occurred despite there being little concrete evidence that ESG investing is accomplishing its purported goals. Without evidence of efficacy, it is impossible for investors with ESG intent to know if they are getting what they are paying for, distinguish among investment managers, or know if they are achieving positive ESG outcomes.
Investors in funds need to be able to target nonfinancial objectives and judge the outcomes in the same ways they manage their financial objectives. This means focusing on the three Rs of a fund: risk, return, and responsibleness. Reporting of risk and return is regulated and standardized, but reporting on responsibleness—or doing good—remains a marketeer’s playground swamped in platitudes and promises.
Investors expect and demand proof that their investments are delivering on their stated objectives. It wouldn’t take long for the asset flows into a fund purporting to deliver 100 percent annual returns to flow out once the fairy tale promises proved to be just that.
Without greater credibility, there will be an inevitable backlash against ESG funds that could lead to capital flows into these funds becoming unsustainable—both in reality and in outcome.
To that end, Invesco is advancing research on the issue of ESG investing outcomes. This work, to be published later this year, will highlight:
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key challenges ESG investors and portfolio managers face in implementing ESG investment mandates,
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guidance on the information required to make informed and effective ESG investing decisions,
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the advancement of practical and material ESG metrics and methods that allow for the targeting of nonfinancial objectives in conjunction with financial objectives,
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a performance evaluation and attribution framework to support the ESG investment management process, and
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the need for the standardization and simplification of fund reporting to allow for the effective evaluation of ESG products.
It is our hope that this work will begin to shift the focus of ESG research toward addressing the needs of real-world investors with ESG intent. In addition, greater monitoring of practical outcomes will allow fund managers to become better stewards of capital and ensure they deliver on the ESG objectives they set.
If funds cannot be judged against the claims they make, the promise of ESG investing will devolve to skepticism, and the opportunity to leverage the free market as an ally to effect change for people, the planet, and for profits will be undermined.
What is needed is delivery against the targets set by funds, not more glossy marketing brochures. What should drive the industry’s focus is the end of the ESG investing process—the outcome.