By Brunno Maradei, Global Head of Responsible Investment, Aegon Asset Management.
Defined benefit pension schemes are fast becoming a relic of the past, while access to capital markets and financial education have become widely available. Individuals are increasingly taking investment decisions into their own hands, and they are demanding transparency, low cost, and choice. In short, a considerable investment risk transfer is happening from institutions to individuals. At the same time, civil society has diversified its campaign targets beyond legislators and large corporates to financial institutions, resulting in significant resources spent on raising awareness of the potential impact of investments on society and the environment.
While these trends are creating a perfect storm in the investment industry and is driving demand for ESG products, we also see that there is an increase in criticism of the performance of these ESG products, arguing that they don’t deliver the positive impact on society or the environment they promise, or that they underperform financially. However, performance measurement and comparison of ESG funds is not as straightforward as it may seem, taking into consideration multiple variables that influence how their success is perceived.
ESG objectives clear as mud
The challenge usually begins with a lack of clarity and mutual understanding between asset managers and clients on ESG objectives. For example, investors may be expecting to have a positive environmental impact when investing in low carbon listed equity funds, but the reality is that such funds have minimal if any impact on the cost of capital for low carbon businesses. There is not a one-size-fits-all ESG objective with a full spectrum of different types of investors all defining ESG success in their own way.
At one end of the spectrum, some investors merely want to ensure asset managers are fulfilling their fiduciary duty in a holistic way, not ignoring financially material ESG issues. They are driven by the growing body of academic research pointing to the superior financial performance of well-managed companies, where good management of ESG issues can be considered a proxy for overall management quality. Such investors are focused on corporate operational practices, selecting the best companies per sector or geography in an attempt to build a portfolio of higher-quality issuers that is expected to outperform the market.
At the other end of the spectrum, an increasing number of investors want to use their investments for positive impact on society or the environment. Impact investment has existed for some time, starting with instruments that blend philanthropy with investment. More recently, however, impact claims have become bolder, and are usually accompanied by offers of competitive market returns alongside measurable positive social or environmental impact.
Somewhere in the middle of that spectrum lie sustainable investors. These investors are more interested in identifying companies well-positioned to benefit from the transformational sustainability shifts happening globally, such as increased spending on transitioning to renewable energy sources or increased interest in healthy food. They might also be interested in operational practices, but ESG for them is a lens through which to analyse corporate activities more broadly – their products, services, and strategy. Such portfolios are by their nature more concentrated, higher conviction, sector-focused portfolios that investors believe will outperform the broader market in the long term. Impact is usually a welcomed by-product of these strategies but may not be systematically targeted, measured or reported: the primary objective is to outperform the market in the long run.
Performance measurement and comparison for such a diverse set of ESG approaches is therefore complex. Investors targeting the use of ESG information simply to beat a benchmark are potentially the simplest to cater for. But even for such investors, attributing financial performance to an ESG approach is far from straightforward. The quality of ESG integration or of the approach to build a sustainable portfolio can vary considerably between different managers, and financial performance is obviously affected by the quality and experience of different managers, their execution capability, and multiple other factors.
Multiple academic studies have tried to examine the impact of ESG approaches on financial performance, often assuming the quality of fund managers to be equally comparable across a set of ESG versus non-ESG funds. Many studies are fundamentally flawed due to bundling of the heterogenous ESG approaches, objectives, and data sources in comparison to similarly heterogenous non-ESG products or market benchmarks. Meta studies suggest ESG approaches at worse fare no worse than their non-ESG counterparts, but ultimately and not surprisingly, the performance of any ESG product depends on multiple aspects of a fund manager’s capability, not just their ESG approach.
ESG data and its analysis is the next challenge. Assessing the ESG practices and performance of issuers remains highly subjective in the absence of accounting or disclosure standards for most ESG metrics. In some cases, standardisation may simply be impossible – for example, to assess the quality of a whistleblowing or health & safety policy. ESG performance metrics such as pollution emissions would benefit from global standardisation but would always need subjective contextualisation: a highly water efficient business in a water-stressed region may need to be rated quite differently to a similar business in a water-rich area. But ESG performance assessment on topics such as labour rights are much harder to assess globally, usually relying on negative news or controversies, which are subject to regional and political bias. Even ESG topics that may initially appear simple, such as excluding controversial weapons, need analysis and discussion: Which weapons? What level and kind of involvement?
One could argue that comparing the performance of ESG indices with their parent benchmarks might be a more objective way to isolate the impact of ESG factors on portfolio performance, but ESG indices are also ultimately biased by the ESG data used to compiled them, which is also far from homogenous: correlation between different ESG data providers’ scores remains relatively low.
Finally, measuring positive social or environmental impact where promised is also fraught with difficulties. Development institutions whose entire raison d’être is to achieve such impacts have struggled for decades with topics such as additionality, attribution, time horizons and measuring outcomes and impacts. Multiple parameters can affect such impacts and isolating one’s direct contribution is the ultimate challenge. For ESG fund managers, impact claims are largely based on the positive impacts the businesses they invest in can have, but this is not systematically disclosed or standardized. Investors’ direct impact in public markets is more limited to the influence they can bring to bear in the companies they invest in, but they must be cautious in attributing positive corporate change – results – to their advocacy activities.
A journey of a thousand miles starts with a single step
In conclusion, assessing the financial, ESG or impact performance of ESG fund managers faces several critical challenges and is far from maturity. First, it is paramount to tease out client ESG objectives at length, often through discussion, since heavily regulated product disclosures are often too dense and cryptic to ensure a common understanding. Second, qualitative, subjective, and holistic analysis remains fundamental, and consultants, industry bodies, data providers and distributors should continue to actively work to improve performance measurement. And third, regulation to standardise disclosures according to strict technical definitions, such as the EU Taxonomy for Sustainable Investments, will also help.
While much is being done to create more clarity on both the supply and demand side, we are at the start of a long journey before investors can critically and reliably assess fund performance against their own ESG objectives.
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