Three big questions facing ESG investors (and how to answer them)

Pendal

May 2024

ESG can be pretty confusing for investors.

The acronym (which stands for Environmental, Social and Governance issues) refers to a jargon-filled investment space which requires an understanding of regulations, methodologies and taxonomies.

And the more ESG evolves, the more complicated it becomes for investors trying to judge the effect of these criteria on their investments.

Why is ESG so confusing? How can you see through the noise?

Much of the confusion about ESG stems from three questions facing investors.

Here we'll try to explain them.

1. Are we looking at the same thing?

Third-party ESG data providers often have different views and methodologies for rating different companies.

That means ESG data requires more interpretation than, for example, balance sheets or credit ratings.

Credit rating agencies may offer different ratings -- but they largely analyse the same numbers from financial statements.

An ESG report can include absolutely everything that has an impact on the macro, meso and micro environmental, social and governance risks a company may face.

There is also the overwhelming challenge of conflation.

A fossil fuel extraction company may be managing its risks reasonably well -- but if investors don't want to invest in fossil fuels then it seems rather irrelevant.

2. Are you saying what I think you're saying?

Everywhere we see advertisements aimed at convincing people that if they invest with a particular manager they'll be able to save the world.

To combat this kind of hyperbole, regulators and gatekeepers have stepped in to reduce potentially misleading and deceptive conduct.

This includes education for clients, longer caveats and attempts at standardising terms such as "sustainable investing".

For investors, this means more surveys, greater reporting, a focus on data and ensuring proper systems are in place.

Regulators are pushing for standard language and consistent data to help people understand what's being said.

That's a positive step -- but more education, more disclosure and more reporting are not enough. People don't read every food label before eating.

Now ESG is starting to be viewed less as a marketing problem and more as a compliance challenge.

At Regnan, we continue to strongly believe that including ESG criteria in the investing process provides more information to make better investment decisions.

3. Does ESG actually affect investment decisions?

Are ESG consideration linked to reality? Does it do what clients actually want? Do ESG funds outperform?

You should be able to find ESG integration statements on most big asset manager websites which outline how they include ESG considerations in their decision making.

Realistically, sometimes ESG considerations might have only a limited influence on an investment decision. But this differs across asset classes.

For example, omitting energy stocks that gained significantly would've made outperformance difficult for some equity strategies over the past two years. But it would have had little impact on fixed income.

How much ESG is included in investment decision-making is ultimately up to clients.

Do you want to invest to make a more sustainable economy and potentially avoid some risks? Or is performance the only thing that matters?

At the end of the day, fund managers, super funds and financial planners are all trying to serve the needs of their clients.

What approach is best? It's about working out what ESG does for different clients.

Some might hate anything that suggests companies need to consider the environment. Some might not want to make the world worse. Others may want to make the world a better place.

These are values judgements.

Here's a very simply way I explain ESG investing:

• If you only care about performance, that doesn't necessarily mean you should ignore ESG funds. Some ESG funds are top performers across the board. ESG approaches may also highlight non-financial risks that can become financial risks.

• If you want to avoid investing in bad stuff, focus on a fund that has negative screens (eg no tobacco producers or controversial weapon makers). What is considered bad may differ between clients, but these type of screens are becoming more uniform.
• If you prefer to invest in good stuff, look for funds that have some kind of process for selection of investments, and some kind of measurement on what those investments are doing.

• If you want really good stuff, look for something that explicitly addresses "impact". There may be more novel strategies available, but there will likely be trade-offs such as having funds locked-up or high volatility in performance.

It's natural for clients to be apprehensive about ESG because it's a new topic full of technical words. But while there are definitely some parts that need more work, there are quite a few of us working on improvements.

Author: Murray Ackman and Regnan

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