ESG. Impact. Sustainable. Does anyone really know what these terms mean?
This question reminds me of the start of my career over a quarter of a century ago. At the time, I joined a small (on its way to being a large) hedge fund in Texas. At that time, hedge funds were actively engaged in the practice of hedging risks they could not control or did not want so they could take only those risks in which they had a high degree of confidence. At least, this is what hedge funds did until they became popular. Then, the term “hedge fund” lost all meaning, or maybe more accurately, it acquired all meanings. Once pop investing culture took ownership of the term, it meant whatever the person using it decided it should mean; the hedging that originated the term “hedge fund” all but disappeared.
As the awareness of ESG, sustainable and impact investing has grown and become a part of the same pop investing culture, these terms have similarly acquired all meanings and, in the process, have been rendered meaningless. At this point, some investors throw up their hands and argue that this is why these issues should be ignored altogether; others decry pop investing culture as bad for markets and society as a whole. We disagree with both of these extremes. On the one hand, we see awareness, transparency and mainstreaming as evidence of progress, beneficial to both Wall Street and Main Street. On the other hand, we believe it is crucial that investors reclaim and reframe these terms before it is too late.
As it turns out, ESG is not an investing strategy. Strategies that claim to “use” ESG can be quite different, with varying degrees of success. But before we can dive deeper into how ESG is used, we must lay the groundwork for what “success” means. For many ESG-oriented investors, success may simply mean that a portfolio of companies scores highly by some quantitative or subjective ESG measure.1 In this case, a strategy is placed on a spectrum of “good” to “bad.” Unfortunately, this kind of snapshot approach doesn’t capture progress or regression toward a goal. Instead, we find that these portfolios miss the opportunity to enable companies who are looking to change. Moreover, this approach doesn’t consider the effect on performance of being “good.” On the other hand, this kind of approach is easier to implement and market, which may be why a majority of ESG portfolios seem to have gone this route.
Here at Zeo, we define success differently. We have made our careers as fundamental investors, and though terminology may have changed over the decades, this basic truth has not: ESG factors are credit factors. Period. A company is not creditworthy if it is behaving in a way that is not long-term sustainable for its business. Especially within credit, every company is dependent on its access to capital markets. If a management team puts future capital raising at risk because it behaves irresponsibly and sets the stage for unexpected liabilities down the road, we believe that is likely to be disqualifying behavior. In this way, we don’t view success as a binary battle between “good” vs. “bad.” We define success the same way we always have as fundamental investors – mitigating risk without compromising performance. By evaluating companies based on their intentional progress toward a sustainable equilibrium, not where they are at a moment in time without regard for their trajectory, we believe we are able to accomplish our goals on behalf of our clients more consistently.
Unfortunately, little data exists to evaluate different styles of ESG investing… until now. Through extensive data analysis, researchers at the Wharton ESG Analytics Lab, headed by Dr. Witold Henisz, have identified six main investment styles which use ESG factors (see Table 1).2
Table 1: Summary of ESG investment styles from Wharton research. The segments with the largest fund inflows since 2007 are highlighted. Note that the descriptions were written by Zeo based on the information provided by the researchers. The segments were determined using factor analysis on 12,916 holdings across 425 ESG-oriented equity-focused mutual funds and ETFs. If the above segmentation were to be applied to fixed income strategies, Zeo would be considered an ESG Integrator.
The analysis reveals some interesting insights. First, they found that only one investment style (ESG Integrators) had a positive correlation between ESG factors and investment performance. They also noted that this was among the most expensive segments, both in the fees they charged and in the amount of effort they put into incorporating ESG issues natively and inextricably into fundamental investment analysis. This makes sense to us. ESG factors are risk factors, so evaluating them properly (i.e. not just as a negative screen) requires a risk management effort, which ultimately is what one is paying for in a management fee. Put simply, the researchers concluded that the higher fee strategies got, on average, better results precisely because of the extra work necessary to engage companies and integrate ESG factors into their investment processes.
On one end of the spectrum are active ESG strategies like these; at the opposite end are indices, which are unmanaged risk by their very nature. Sadly, the ESG investment styles that saw the largest asset inflows since 2007 were not the best performing but rather funds closer to this passive end of the spectrum, which tend to use exclusion-style screens as their primary method for considering ESG issues. Why? They have lower fees and are from the largest fund families. Meanwhile, the research also showed that managers seem to benefit most from selecting for high ESG scores (i.e. companies that look good in one-time snapshots), while they were not rewarded for selecting investments which showed ESG improvement (i.e. companies that actually made progress).
Put another way, managers are most successful using low-cost simple screens even if the data shows that approach doesn’t seem to work, and their clients are left holding the bag.3 Even so, the flows show where investor focus is, and this may begin to explain why ESG strategies have a reputation for forcing investors into a tradeoff between performance and progress. It also explains why some managers knowingly “greenwash” their portfolios.4 It is little wonder why ESG skeptics think the way they do. However, investors play a supporting role here, not paying much attention to the differences in styles and focusing primarily on factors that don’t drive performance.
So what is the meaning of ESG? ESG cannot be a term for a particular style of investing. To date, treating it as such has incorrectly equated very different strategies and forced counterproductive apples-to-oranges comparisons. It is, rather, a term for a specific subcategory of risks that companies face regarding effects they have on stakeholders and society which fall under the areas of Environmental, Social and Governance issues. The differences in how these ESG risks are considered in various portfolios is nuanced but important. With funds flowing to strategies in which ESG efforts are negatively correlated to financial performance, and with this noise obscuring the potential for superior risk/rewards elsewhere within the ESG landscape, it may be time for investors to reevaluate the meaning, and purpose, of ESG in their portfolios.
By Venk Reddy
Originally published in Q1 2021 letter
1 The ESG rating method being created by Morningstar to evaluate ESG portfolios falls into this category. Suffice it to say here that we believe this method to be tragically flawed for too many reasons to enumerate in a footnote. But the use of a globe icon is sheer marketing genius.
2 Though this particular research is yet to be published as of March 31, 2021, the researchers presented a preview in November 2020, and we have received permission to share some of the most interesting takeaways. It is worth highlighting that, in our experience, the styles of investing do not differ between equity and credit, with one caveat being that the most active styles are much harder to find in fixed income. That said, the methods (i.e. what it means to be active or how a manager integrates ESG) differ greatly. Note that when we discuss data here, the researchers used the ESG data service developed by TruValueLabs, a firm with which Zeo has partnered as well due to their emphasis on raw data and AI-based analysis, which allows firms like ours and groups like the Wharton ESG Analytics Lab to draw our own conclusions rather than rely on someone else’s research or ratings.
3 This is a good place to remind readers that the business of asset managers is to raise and retain capital, and their product is the investment portfolio. Sometimes, portfolio performance (better product) and asset growth (successful business) are aligned. Unfortunately, here they don’t appear to be at the moment.
4 The researchers at Wharton used this pejorative term, “greenwash,” to describe what managers were being incentivized to do in the current ESG investing environment where funds flow to low fees and large fund families. And it pays off. They also highlighted that 70% of ESG-oriented equity-focused assets were held by the ten largest fund families. In other words, it will take a concerted effort to redirect both traditional and mission-driven investors in a more productive direction.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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