The advent of the Joseph Biden administration will likely create a significant tailwind for environmental, social, and governance (ESG) fund products in the United States and accelerate their already torrid growth.
Under the outgoing Donald Trump administration, the Department of Labor (DOL) amended the Employee Retirement Income Security Act (ERISA) to specifically prohibit pension trustees from considering ESG factors in selecting investments and managers despite objections from many industry participants.
The new administration will probably reverse this prohibition in short order, opening the door for a potential proliferation of new ESG products introduced through the 401(k) channel and in the segregated mandate market.
US managers have been slower to board the ESG bandwagon relative to their European peers. How can they catch up?
Active managers have seen significant growth in the ESG investing segment, especially in equity and fixed-income funds. To access this growth, asset managers will be pressured to show that their commitment to ESG integration goes beyond superficial lip service. They will need to demonstrate that they have fully incorporated ESG principles into their investment processes.
“Greenwashing” accusations have risen alongside the rapid growth of the ESG category. Some funds labeled as “ESG” are only nominally incorporating these considerations. In Europe, regulators have responded, imposing ESG reporting requirements starting in 2021 in an attempt to ensure that the labels are accurate.
In the United States, the SEC has not made detailed reporting as big a priority. But investors themselves, particularly institutional asset owners and consultants, will want proof that the ESG label is more than just a “wrapper.”
This is a key challenge for asset managers. In many cases, ESG teams have worked in relative isolation, separate from the traditional fundamental investment teams. They must support multiple products, both specialist ESG funds focusing on climate change, clean energy, etc., and as an overlay for non-specialist funds. Integrating ESG principles into the latter category may require traditional fundamental investors to embrace new analytical frameworks.
ESG research tools are also more varied and nuanced than the research inputs of traditional strategies. They include databases, research from both investment banks and independent research producers, proxy advisers, sentiment trackers, web-scrapers, and all manner of specialists that reflect the range of activities and objectives contained in the United Nations (UN)’s 17 Sustainable Development Goals (SDGs):
UN Sustainable Development Goals (SDGs)
Given the broad spectrum these SDGs cover, every aspiring ESG fund asset manager must decide where they will focus and what ESG implementation strategies they will employ and to what proportion.
ESG Implementation Strategies
The first ESG funds were primarily exclusionary in nature. They avoided companies associated with tobacco production, arms manufacturing, carbon energy, etc. But ESG has evolved to include more nuanced approaches, including investing in firms that are taking active steps to meet these SDGs and to engage with company management.
Consequently, how asset managers demonstrate ESG integration research in their overall investment processes will be a function of the ESG strategy choices they have made. The following diagram distills those choices:
Part of the integration process should address how and to what degree various funds are using ESG research inputs. In the longer-term, the distinction between ESG and non-ESG funds will blur.
ESG research inputs are particularly difficult to value because of the variety of ESG approaches and implementation strategies that managers use and because important ESG research inputs—databases, for example—do not lend themselves to document or interaction counting.
This raises three key questions:
- How can managers value ESG research inputs given the manager’s particular ESG process; input diversity (data / documents, etc.); and at the fund or client level?
- How can managers demonstrate ESG integration in their wider research process to clients and other stakeholders?
- How can managers determine whether incremental ESG research spending should be internal or external?
What is required is an ESG research valuation process that can overlay the manager’s existing research valuation methodology so that the ESG research inputs can be valued based on the manager’s ESG product and implementation approaches. That process should also demonstrate how those approaches are applied across all of the manager’s funds.
This can then be augmented by benchmarking research spending.
Managers that can demonstrate this to asset owners and consultants will be well positioned to capture the growth opportunity that ESG offers.
Further insights on ESG integration are available at FrostConsulting.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Gabriel Shakour
Neil Scarth is a Principal of Frost Consulting, which works with asset managers and asset owners on a variety of research issues including research valuation/budgeting software platforms (FrostRB), strategy-level research spending database/benchmarks (FrostDB), and investment process ESG ratings. He has held a wide range of roles in asset management and investment banking in both Europe and North America, ranging from running equities businesses at global banks to launching and managing all aspects of varying asset management products. He has also published on related topics with CFA Institute, Stanford University, and the University of Edinburgh.