We are currently seeing a huge growth in demand from investors for products reflecting environmental, social and governance (ESG) concerns, such that this trend can no longer be dismissed as a fad.
Earlier this year, financial analysis and research group MSCI put a figure of $20 trillion on the total of ESG investment products in portfolios – about a quarter of all funds under management, according to McKinsey & Co. This proportion seems likely to grow further as more asset managers offer ESG products to their investors.
But as ESG-related investing has moved from niche activity to the mainstream, the question arises how to measure the performance of the managers in question. After all, while ESG investing is about ‘doing good’, as with all investment, it is also about getting a return.
The way in which we measure ESG investment performance can have a significant effect on the direction that such investment takes. More on that in a moment.
First, what sort of comparisons would it be useful to make? Simply setting an ESG manager’s performance against another index, such as Standard & Poor’s 500 index (arguably the most influential benchmark in the world) would be both unhelpful and unfair. The S&P 500 contains a number of so-called ‘sin’ stocks, representing corporate interests in industries such as tobacco and others that would not feature in many ESG portfolios.
These sin stocks have an average annual return 2.5% higher than that of their ‘ethical’ fellows, as evidenced here.
So, the S&P 500 and similar indices, such as London’s FTSE 100 index, are not an appropriate yardstick by which to judge an ESG manager’s performance. For this reason, a number of specifically ESG-related benchmarks are coming into play, such as those offered by MSCI and FTSE Russell.
In time, these indices will become increasingly important, in line with the expected continued expansion in ESG investing. This, as we shall see, will make it evermore pertinent to know how these benchmarks are constructed in terms of what is included and what is not. One might think it’s a relatively simple business of excluding, for example, stocks in fossil fuel-based firms and packing the benchmark with shares in wind turbine manufacturers. The reality is rather more complex.
“When a stock is in the benchmark, managers will hold it, pretty much no matter what happens”
Indices of any sort, ESG or not, are far from neutral in their influence on asset managers. When a manager is benchmarked against an index, they are naturally encouraged to hold the stocks in that index. This is not the same as the automatic purchase of index stocks seen in passive investment strategies, designed to mirror precisely the composition of the index. Rather, the holding of index stocks mitigates the risk that the manager will underperform against the benchmark.
In this regard, an active manager is not that different from their passive counterpart. But if the relationship between the manager and the benchmark is not neutral, nor is the effect of inclusion in a benchmark on the company concerned. Precisely because managers are encouraged to hold benchmark stocks for no other reason than that they are included in the index concerned, the issuing firm is, in effect, able to rely on this ‘inertial’ support to raise capital more cheaply than would otherwise have been the case.
When a stock is in the benchmark, managers will hold it, pretty much no matter what happens. This gives the firms in question a lower cost of capital than those outside the benchmark; a benefit that I have called the ‘benchmark inclusion subsidy’. Some may object to the use of the word ‘subsidy’, which is more usually associated with a handout of taxpayer money from a government or other public authority. In this particular case, it is effectively a handout from asset managers to firms included in the benchmark.
The effect is similar to what would be expected from the distribution of a subsidy as conventionally understood. It is widely accepted that, all other things being equal, the subsidising of something results in more of that which has been subsidised coming into being. Thus, the type of firms being subsidised in this way are likely to experience greater expansion than those outside the benchmark, while any company whose stock is removed from the benchmark will lose what amounts to a growth subsidy.
In the pursuit of this growth, firms are able to take more risks than would have been the case outside the benchmark. For example, they may increase investment or engage in merger and acquisition (M&A) activity. In effect, the prospects for such inherently risky projects are judged by investors against less stringent criteria than would have been the case outside the index, simply because of the benchmark subsidy. The hurdle that firms have to clear is lower than it is for those outside the benchmark.
There are few riskier activities than research and development, in which the hazard of consuming capital to no good effect is ever present. This is especially so in sectors such as advanced technology and pharmaceuticals, where so-called ‘blue-sky research’ – that which breaks completely new ground – can yield huge profits… or nothing.
Thus, there is a direct link between inclusion in the benchmark and the availability of funds for R&D. This may seem an unexceptional statement, especially as there is no obligation for benchmark member firms to use the subsidy in this manner. As we have seen, they could spend it on M&A or capital investment – or even just on nicer office accommodation.
In fact, however, the R&D connection has a special significance which, in turn, places a particular responsibility on those who construct these benchmarks and in effect decide who gets the subsidy and who does not. Look at the question this way: what sort of R&D does society want to encourage?
“The responsibility on those selecting stocks and bonds will be heightened by increasing investor awareness of ‘greenwashing”
In terms of ESG business activity, it may seem obvious that desirable R&D activities are to be found in areas such as renewable energy, organic agriculture and social enterprises – but it may not be as simple as that.
For example, the question whether a fossil-fuel company could be included in an ESG benchmark may seem ridiculous, yet such a company could find a place, albeit at a lower ‘weight’ than it would have commanded in a conventional benchmark, especially if it were working to lessen its dependence on fossil fuels and to seek new sources of energy.
This sort of R&D could be expected to meet with at least qualified approval from ESG investors; thus they may be less likely to object if such a firm benefited from the benchmark inclusion subsidy, but the picture would be clouded if the company was simultaneously undertaking this sort of R&D and using some of the subsidy to merge with or acquire other fossil-fuel companies, thereby enlarging that particular stock’s exposure to this sector.
In other words, there are no easy answers and there is a heavy responsibility on those who construct ESG benchmarks to know precisely what sort of businesses they are encouraging or discouraging, with a special reference to the likely impact on each company’s spending on R&D. Those who put these benchmarks together are, in effect, gatekeepers for the subsidy.
So, how large is this subsidy? Our research shows that, in the case of inclusion in the S&P 500, it is meaningful, to say the least. We estimate that firms in the S&P 500 benefit from a 30 basis points to 90 basis points (0.3% to 0.9%) lower cost of capital. Put bluntly, whether your company is in the S&P or not is a very big deal.
Are ESG benchmarks anywhere near as important and influential as this? The short answer is: not yet. But the rising demand for ESG investment products can only make them evermore significant and, as they become so, the benchmark subsidy will, by definition, increase alongside the almost-mechanical inclusion of their stocks in ESG portfolios.
We have been discussing equities, but something similar is likely in the bond market space, with ‘green bond funds’ offering investors a fixed-income route into ESG companies. Again, a firm whose debt is held by such funds is likely to be able to raise capital more cheaply than one that is outside such a fund.
The responsibility on those selecting stocks and bonds for such benchmarks and portfolios will be heightened by increasing investor awareness of ‘greenwashing’; the application of an ESG veneer to what are essentially conventional businesses in the hope of attracting ESG-minded investors.
As the benchmark subsidy grows, so will scrutiny of the processes by which companies are either included or excluded, a development likely to be welcomed by most ESG investors.
ESG investing – aka ‘ethical investing’ and ‘sustainable investing’ – covers environmental, social and governance issues, this last referring to the entire question of how a company is run and how it conducts itself more broadly. ESG investing has expanded in line with a growing public demand for products that conform to generally agreed criteria. Last year, the Global Sustainable Investment Alliance, a membership body, reported that a survey of managers asking their reasons for embracing ESG investing, found: “The leading motivation, based on the number of money managers citing it and the assets they represent, is client demand.”
In March 2017, a survey sponsored by State Street Corporation found an overwhelming majority of institutional investors, 92%, wanted companies explicitly to identify those ESG factors with a material effect on performance, and 46% of retail investors wanted to see more companies reporting ESG performance-related data.
Lack of standardised, transparent data was a problem for 60% of institutional investors and 46% of retail investors. Overall, State Street found that traditional obstacles to environmental, social and governance investing "are fading”.
In September last year, David Zahn, Senior Vice President at Franklin Templeton Fixed Income Group, said: “A new generation of investors is taking a lead in shifting sentiment. We recognise many younger investors appear to be much more concerned than other generations about where their money is being put to work.”
He added: “Doing the right thing for the environment and making money do not have to be mutually exclusive.”
And where younger investors have led, it seems the wealthy are following. A report in the Financial Times in May 2019 quoted a number of wealth managers including Emma Hunt, of St James’s Place, who said that ESG has become a mainstream concern for clients. “We’re definitely seeing a growing appetite for ESG. It’s mentioned in most meetings now, which is a huge shift.”
In August this year, Investors Chronicle declared: “Green is good,” noting a growing belief that an ESG focus can actually improve shareholder returns, adding: “Regardless of the personal stance investors have on subjects such as climate change and workers' rights, these issues are becoming increasingly important considerations for anyone that is on the hunt for the best investment opportunities of the coming decades and wants to reduce the likelihood of truly ghastly losses.”
Anna Pavlova is Professor of Finance and Academic Director of the AQR Asset Management Institute at London Business School