ESG ETFs have seen steady but strong growth over the past five years with notable uptick in the last 12 months. Of Europe’s circa €1trn ETF market, over half of all new inflows to ETFs at the start of the year were ESG focused.
This marked and steep climb in the uptake of ESG ETFs suggests that the trend towards passive in the wider fund management sphere is now being replicated in ESG investing.
The increasingly widely held view that ESG is no longer a niche differentiator or asset class but rather a fundamental investment strategy – and hence should not be over-priced – has also driven the rise in the popularity of ESG ETFs. While this does not paint a full picture, or imply we have reached an endgame, it does speak to an alpha generation opportunity via active strategies in the shorter term.
The active advantage
Alignment with the fundamentals and core principles of ESG investing requires good judgment, quantitative analysis and ultimately empirical proof to accurately assess the underlying factors within an ESG investment. This speaks to the wider ESG conversation around who is to be the ‘judge and jury’ when determining what should, or should not, fall under the banner of an ESG investment.
The latest taxonomy rules will help level the playing field through a common language and use of terms for the ESG conversation and therefore reduce the marketing fog, whilst Task force on Climate-related Financial Disclosures (TCFD) and SFDR (Sustainable Finance Disclosure Regulation) type rules will no doubt cast a clearer light on both ESG-related impacts and the integrity of subsequent disclosures relating to those impacts.
That said, regardless of the plethora of new rules and regulations to which they must adhere, a fund manager will ultimately still need to exercise increasing levels of discretion and judgement regarding a target stock’s ESG ‘credentials’.
Therein lies the active investment opportunity. The spotlight has already fallen on the quality of traditional ratings providers and the inconsistencies across their datasets when it comes to qualifying ESG investments.
When looking at the most mature and developed indices, such as the FTSE 100, Dax30 or S&P 500, there is minimal disparity across the credit ratings agencies when it comes to non-ESG metrics. Typically when financial analysis by the major credit agencies does diverge in any material fashion, it manifests as a difference between one rating level and the very next.
The ESG rating for a specific company or stock, by contrast, can be markedly different from one provider to another. The major challenge lies in how firms’ own proprietary methodologies are combined with the new sources of data that are required to assess ESG credentials, as this makes for some wide ranging answers from the ratings agencies – which in turn raises questions of trust and credibility.
See also: – Social policies have a lot of catching up to do
Our own recent proprietary analysis compared a number of the traditional ratings agencies’ respective ESG ratings on top stocks. There were notable differences between the same two ratings agencies, including a 2.8x deviation on scoring for Wells Fargo, the same for United Health Group, while Boeing and Walmart saw a 2x deviation in their respective ESG ratings. Furthermore, when digging into the underlying E, S and G sub-scores, Walmart had a score that was six times better/worse when it came to the measurement of its Social ‘value’ by the same two agencies.
The science here is still immature: one traditional credit rating agency’s ‘green’ stock could be another agency’s ‘brown’ investment due to the application of their respective divergent ESG methodologies. A proprietary view offered by an active manager, based upon their own research and superior sustainability insights, will accordingly offer a value/alpha differentiator.
Conversely, it is also true that a growing proportion of investors are not prepared to pay a significant premium for active ESG investment advice, which has driven the popularity of ESG passive approaches. In this sense, ESG investing is now simply too mainstream. Accordingly, to justify an active fee, careful curation of data sources or providers will be key, which in turn is further enhanced by the focus the fund manager places on the individual weighting of ESG factors within the portfolio.
Active managers on top for now
Until passive funds can consistently demonstrate superior ESG investment returns, we should expect to see an ongoing split between those investors willing to pay for a ‘purer’, more clearly validated version of ESG as part of an active strategy, and those who choose the lower fees but potentially questionable ESG credentials of a passive strategy.
Ultimately, active differentiators and style choices will lead to value creation through superior alpha insights, taking into account a new layer of ESG market risk and a new landscape of ESG parameters by which to judge a company’s performance and the overall financial opportunity.
Given this dynamic, and in line with any aggregated investment theory versus active approach, in the mid to longer term the ‘right’ active approach should derive a superior return over and above a market proxy ETF that incorporates ESG elements.
Although the investment world is slowly but surely becoming better equipped to identify the ‘right’ data to validate ESG credentials, and the wider world likewise is moving towards a true consensus on ‘what good ESG looks like’, there remains nonetheless ample opportunity to deliver superior stock selection on the basis of an active manager’s own in-house ESG research and fundamental convictions.
