Maryna Chernenko, Managing Director of UFG Capital, writes that even though we are at the early stages of impactful investing and there are lots of challenges for asset managers lying ahead, the future path of the balance between portfolio profitability and sustainability is clear already.
Although once just a theoretical concept, ESG is today a reality that asset managers must address as strategically important.
According to Refinitiv Lipper, ESG funds globally received inflows of USD649 billion in the first 11 months of 2021, representing a 20 per cent increase from 2020 and a 128 per cent increase from 2019.
The same situation can be seen in fixed income. According to a VettaFi analysis, the first half of 2022 saw the ESG versions of fixed income ETFs managed by Blackrock, Vanguard, and Nuveen receive a net inflow of USD888 million, while the non-ESG counterparts saw USD9 billion of outflows.
This is surprising given that energy equities have been the best performers this year alongside commodity equities. Further, ESG versions of these ETFs tend to have higher expenses and have historically underperformed by eight basis points to a full percentage point.
All these go to show that ESG investing is no longer a fad, is here to stay, and will likely permeate all aspects of asset management.
Challenges of incorporating ESG into asset management
Although tremendous strides have been made in implementing ESG in asset management, several challenges remain. Firstly, the mainstream investor is still not yet ready for ESG. Despite the explosive growth, ESG funds represent a small portion of the capital markets.
According to ISS Market Intelligence, US ESG mutual fund and ETF assets represent just 1.4 per cent of total US mutual fund and ETF assets, despite growing by 33 per cent in 2021.
Amongst retail investors, despite a general interest in ESG and intention to do good, action has been lacking, as found by ISS’ The State of the ESG Fund Market report. We also see this in other parts of the world, such as in Singapore. A survey there found that although more than eight in 10 respondents recognised the importance of ESG investing, only 8 per cent see ESG investing as leverage to drive environmental and social changes. For the situation to change, the ESG regulatory landscape has to broaden, and greater transparency and consistency in reporting are required.
Secondly, due to the many different interpretations of what ESG constitutes, asset managers have struggled to use ESG to guide asset allocation to achieve an efficient frontier. As such, ESG is primarily used as a risk management tool, as it is easy to measure and quantify.
For instance, a Moody’s report has found that moderate to severe ESG events, particularly around public controversies, can cause stock market losses of -1.3 per cent to -7.5 per cent over 12 months. As such, asset managers use ESG checklists to screen specific risk factors (e.g., carbon emissions, waste management, regulatory compliance, etc) to filter out these companies from the investment universe.
However, the ESG checklists today fall short of measuring several factors, such as intangible assets (e.g., R&D, innovation capital, organization capital), which are increasingly important. There have been attempts to measure organizational capital, such as Diversity and Inclusion standards (e.g. board diversity). However, such metrics can be “gamed,” and many companies do not report detailed data.
How asset managers can approach ESG investing
Firstly, given the vast array of ESG methodologies and reporting stands, asset managers must first define their sustainability beliefs and ensure stakeholders are aligned on the approach to achieve these beliefs. That will help guide the capital allocation and capital oversight process.
Next, different asset classes offer different flavours of ESG investing. Equities, for instance, allow investors to vote and participate actively. Information is also publicly reported and available.
As for fixed income investors, they may not have the ability to be as active, but they can still influence and encourage companies to implement ESG factors into a company’s operations. In recent years, we have also seen the emergence of green bonds or climate bonds, a sub-asset class to raise capital for climate and environmental projects.
Thirdly, there are also other tools that asset managers can use, such as using derivatives to match assets with liabilities in a cost-effective and capital efficiency way. Carbon credit is another asset class that has been gaining popularity among companies and investors. The 2021 COP26 global climate conference has also introduced the first-ever multinational agreement on carbon credit trading standards.
The future of ESG investing
Despite all the talk of ESG in recent years, we are still in the very early innings of widespread adoption of ESG. Greater regulatory teeth will be needed, and consistent reporting standards will need to be adopted.
However, for the movement to be sustainable, asset managers must be able to achieve or balance both profitability and sustainability without having to sacrifice one for the other.
Results have been promising. For instance, the MSCI EM ESG Leaders Index has returned +14.5 per cent p.a., compared to the MSCI EM index, which returned just 10.7 per cent p.a. over the last decade. A study by MSCI has also found that investors can theoretically improve the ESG and climate profit of their income allocations without sacrificing yield or causing a high tracking error.
We look forward to investments being both financially rewarding and impactful.