What exactly is ESG?

The three-letter acronym, ESG, is among the most widely used, but arguably one of the least understood concepts in the investment world.

Despite no real consistency on how it’s defined or applied, ESG – literally meaning environmental, sustainable and governance – has moved from the fringes into the forefront of decision-making for asset managers, institutional investors and company directors.

While there have been attempts to standardise ESG across the industry – notably the Investment Association’s new responsible investment framework – there remains a long way to go.

Investor influx

One thing is clear: huge amounts of money are being invested in ESG funds. Assets under management in ESG products in the UK have doubled over the past five years, from £17bn in 2014 to £35bn in the first three quarters of 2019. Globally, ESG investments account for about one-quarter of all professionally managed investments, at $23 trillion in 2017. With more and more funds being launched, this number is expected to grow. 

It goes beyond investment strategies. “ESG seems to pop up in one form or another in every set of company board minutes”, says Paul Poletti-Gadd, Solutions Director at FundsLibrary. In fact, 36% of C-suite and board members say investor pressure has increased their company’s focus on ESG, according to a KPMG International survey.

But the term ESG is very fuzzy; although the IA is taking steps in the right direction by sharing industry-wide common language, there’s not yet one widely accepted definition of ESG, nor a globally agreed set of standards. 

For example, people have very different ideas about what constitutes an ethical or sustainable investment. A survey of financial advisers earlier this year, by Cicero, illustrated this very well: while there was agreement that the likes of weapons-makers shouldn’t be found in an ESG portfolio, only 29% said mining or fossil-fuel industries should never be included. 

This fuzziness means that ESG is always at risk of being written off as merely a buzzword or badge of honour. Or worse, with little regulation as to how funds are labelled, there’s a risk it could result in the next mis-selling crisis. That was a major concern for almost all of the financial advisers in the Cicero survey.

A heavy burden

Fund managers and analysts already have their work cut out, getting under the bonnet of a huge number of often multinational, diversified companies.

But ESG means asset managers must find out a lot more about a business. They must make fair comparisons, weeding out the green-washers. It’s not just a question of crunching the numbers or grilling the CEO. How do you, for example, get to grips with the level of human rights protection in a company’s supply chain? For funds of funds, there are additional, huge layers of complexity. 

What about returns?

Ultimately, how can investors – from the man on the street to pension fund managers – use such a loose concept as ESG to compare and contrast investments? How do you compare a portfolio if different measures of ESG are being used?

And, crucially, does ESG investing create better returns? You can find research pointing in either direction. 

However, one of the biggest pieces of research, a study by Morgan Stanley on the performance of nearly 11,000 mutual funds and ETFs from 2004 to 2018, found no trade-off in returns of ESG-focused funds compared with other funds, and in fact they had lower downside risk.

For younger investors, returns aren’t the be all and end all. There are other considerations too; they want to make a difference. Research has shown that millennials are twice as likely to choose funds based on ESG considerations compared to baby boomers. 

Paul comments: “Millennials are more conscious of environmental and sustainability issues and want to make sure that mindset is reflected in their investment choices. To a certain extent, millennials can afford this mindset. They have a less traditional outlook and are possibly more willing to experiment”. 

What needs to happen?

ESG is here to stay and can be a force for good. But it’s clear that more consistency is needed in how environmental impact, sustainability and governance are defined and measured. There’ll have to be standardisation so people can make comparisons and make informed investment decisions.

Steps are being taken in the right direction, not least the IA’s efforts at standardisation. But there isn’t yet the harmonised approach that’s so desperately needed.

Paul says: “This isn’t going to happen overnight. So, it’s beholden upon anyone at any level in the asset management industry to think twice when confronted with the ESG acronym and scrutinise any claims as carefully as possible.”

He adds: “FundsLibrary keeps a weather eye on topical themes and updates within the industry at all times. We are staying close to this topic and will keep our clients informed of any implications as the conversation evolves. We are always happy to help with any query or clarification whenever necessary, whether it be regulatory, data or other”.

We can be contacted on +44 117 980 9994 or here.

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All figures correct as at 30.09.2019.