Is the sustainable investing industry sustainable?
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Environmental, social and governance (ESG), socially responsible, responsible, sustainable, ethical, impact and green are all terms used to describe investment in firms that exhibit good behaviour. However, the number of terms and confusion about the differences between them are just two of many challenges faced by those investors who also wish to behave well.
Consistency is important. Mathematical systems that are inconsistent break down. Politicians and the police must themselves follow the rules they write or impose, or society risks unrest. Encouraging good corporate behaviour is important on many levels and the financial sector has a responsibility to build a sound framework for the sustainable investing industry, one that is consistent and can thus be trusted.
Do well by doing good?
Of course, what constitutes good behaviour is hard to define. There is no rulebook, as is the case with a legal system. We understand that the principle of ‘cruel to be kind’ is ethically sound with respect to bringing up children, but what about companies?
Is it ethical to invest in a weapons manufacturer whose products end up in the hands of Ukrainians trying to defend themselves, or unethical? Should the big oil companies be involved in the process of weaning us off fossil fuels, rather than being pressured to sell assets to private equity firms that can operate them away from the glare of public opinion?
Originally, the idea behind sustainable investing was that by steering investment away from firms behaving badly, it would push up their cost of capital. This would reduce their return on capital and impact their performance. In other words, good behaviour would be rewarded with better returns.
This, however, has not transpired. The MSCI World ESG Leaders Index has returned 10.8% per annumin US$ terms over the past 10 years, compared with 10.7% for the MSCI World Index.
Sustainability means sacrifice
One explanation for this is that sustainable investing is, as the author of the Wikipedia entry puts it, about “evaluating the extent to which a corporation works on behalf of social goals that go beyond its role to maximise profits on behalf of shareholders”. By this logic, any shift away from profit maximisation would necessarily reduce profitability.
Also, by making the responsibility to behave well voluntary, the role of governments is diminished. It is important that legal bars are raised in line with, if not ahead of, ethical ones. Until both are pulling their weight, some investors may choose not to invest sustainably, recognising that good corporate behaviour must be driven by law and self-interest, not altruism.
The benefits of disposing of our waste products such as plastic and carbon dioxide that we have allowed for decades to pile up on our proverbial doorstep will accrue to future generations.
However, it is current generations that will incur the cost, and this means having less to spend on other things, cable TV and avocado toast, for example. In other words, a focus on sustainability involves sacrifice.
This though should not be seen as a threat to sustainable investing. Sacrifice is something that is well understood and practiced by many. The threat, if there is one, is continuing to pretend that sustainable investing does not involve sacrifice.
I was pleased to read recently that some big fund managers would like disclaimers put on sustainable funds warning of the possibility of lower returns. It is important we take our collective head out of the sand, even if being told by the financial industry that money isn’t everything is galling.
All passive funds track an index. And most active funds employ one as a performance benchmark. Indices require quantitative criteria that determine constituents. In the case of, say, small caps or high-dividend stocks this is straightforward. However, good corporate behaviour is subjective, so harder to score quantitatively.
Mistaken identity
Index providers have fallen over each other to build the preeminent sustainable investing scoring framework, as well as to launch the most indices. One of the main providers has by my count launched more than 100 distinct sustainable investing indices. Across the entire industry there could be close to 500!
Funds, both passive and active, have proliferated alongside indices and I have sympathy for anyone trying to decide which one to buy. Free online resources such as Trustnet and Yahoo! Finance may help in this endeavour.
Moreover, there is a belief that an investment style such as ESG can be encapsulated by an index in the same way that value indices have become synonymous with value investing. The criteria for value indices can be written on the back of an envelope. The bible of value investing, Security Analysis, written by Benjamin Graham and David Dodd, and first published in 1934, comes in at 700 pages!
Another issue is that because index criteria are necessarily in the public domain, they can be used malevolently. A knowledge of them enables companies to fake good behaviour, helping them gain entry to an index or to increase their appeal to active investors, known as greenwashing.
The sustainable investing industry is facing an identity crisis – one that could threaten its very own sustainability.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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