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Tom Burroughes

8 May 2019

The world’s wealth management sector is full of acronyms. Remember the BRICs (Brazil, Russia, India and China)? One minute they are only understood by finance geeks, and then, suddenly, they are on everyone’s lips. And few terms seem to have grown as fast as ESG, aka environmental, social and governance-themed investing.

This is why ESG is going to be featured in these pages throughout a series of interviews and profiles in coming days, not least so that readers can get a handle on what the trend actually means. 

ESG investing typically relates to how holders of wealth can use their financial muscle to steer money towards areas deemed to be positive because of their effect on the environment (such as renewable energy) and away from harmful forms (such as fossil fuels); and similarly to encourage investment that helps reduce child poverty, improves literacy and access to healthcare. And it can also be about making firms and those who own them more accountable and responsive. The approach goes behind just screening out "bad" investments and often involves ways of encouraging "bad" firms to be better.

We financial journalists get press releases and other messages on ESG daily. Yesterday (7 May 2019), as I wrote these words, I counted 12 emails referring to the term (and that didn’t include stuff in my spam folder). To take one at random: Robeco, the European investments firm, is rolling out an e-learning programme for private bankers at Standard Chartered so that ESG ideas can form part of their training. In another case, an organisation commented on how well - or not - fund giant BlackRock was faring as an ESG investor. The news flow is now a torrent. 

Growth in ESG activity has been rapid. The number of ESG-based assets rose by 37 per cent year-on-year in 2017, reaching $445 billion, outpacing the 23 per cent rise in the MSCI World Index of developed countries’ equities. Twice as many ESG-themed funds were launched in 2017 than was the case in 2014, with exchange-traded funds proving a popular channel, according to the World Resources Institute. 

Large groups such as UBS and BNP Paribas, and others such as Columbia Threadneedle, Indosuez Wealth Management and Crossmark Global Investments (the latter in the US), operate in the field. ESG is also affecting hiring. The other day, East Capital hired a chief sustainability officer. It is driving new products: fund-tracking organisation Morningstar now produces reports on where the good and bad guys of ESG are. There are indices and rankings coming to market.

There appear to be several drivers of all this. First of all, it could be argued that the financial services industry sees ESG as part of its way of winning back respect after 2008. Bankers would rather tell clients about all the good their wealth could do in the world, rather than remind them about financial institutions being bailed out by the taxpayer. A decade ago, talk was all about “too-big-to-fail” banks, sub-prime mortgage foolishness, central bank monetary complacency, global “imbalances”, weird and dangerous derivatives, and conflicted rating agencies. The reputation of capitalism, perhaps unfairly considering that 2008 was often as much about the state as private enterprise, got trashed. A way to recover that reputation could involve something such as ESG.

This is not necessarily about cynical marketing. Coupled with worries about modern finance are concerns about what humans are doing to the planet. One does not have to fully buy into the alarmist case over global warming (and this publication prefers not to wade into scientific controversies) to know that there are a lot of problems. Air pollution in mainland China’s industrial coastal region, to give one example, is shocking to anyone visiting the region for the first time. The same goes for other developing and some developed countries. Television documentaries about eroding coral reefs, plastic waste in the oceans, species loss, and the sheer ugliness of certain developments, all adds to the public's fears. This drives concern, particularly among younger high net worth adults who are raising families, about what they will be able to hand on. A lot of ESG investing pressure is therefore coming from those famed Millennials (but not exclusively). 

Wealth managers want Millennials’ business and know that if they are to avoid the axe, ESG has to be on the main menu. It should not be something they have to make a special request for, such as gluten-free meals. And wealth managers also need to embed ESG ideas into their client reporting. We recently ran a set of features about client reporting as a vital way for wealth managers to engage with clients. ESG is going to be part of the reporting mix. Firms such as France’s Indosuez Wealth Management, for example, are particularly keen about this point.

At the more hard-nosed end of the street are those who argue that ESG investing is not about sacrificing returns and going without, but about better investing - period. In 2015, DWS, the fund management arm of Deutsche Bank, conducted a meta-study, along with the University of Hamburg. It examined about 2,200 academic studies that had looked at the relationship between ESG and financial performance (source: Forbes, 20 Sept, 2018). It revealed that about 90 per cent of studies showed a non-negative relationship between ESG and financial results. ESG advocates say the approach flags problems that might hurt a company’s performance later on. If a firm trashes the environment or is secretive, chances are that its share price will also suffer.

There appears to be some difference in focus between the “E” – environment – “S” – social – and the “G” – governance. In some ways governance is not as media-friendly a topic as the other two, but arguably it is the most important. The rise of “passive” index investing and regulatory costs has made shareholder activism in some ways more difficult. (This is one of the paradoxical effects, perhaps, of the European Union’s MiFID II directive which has squeezed sell-side research.) With many firms preferring to stay private rather than take the IPO plunge and go public, businesses are in some ways less transparent than before. How can shareholder activists flex their muscles if so much goes off the listings? This may explain why one of the top challenges for ESG investing is in the fields of corporate debt, private equity and credit, where data is harder to get hold of. And then, of course, there is the challenge of how sovereign wealth funds in regions such as the Middle East can be held accountable for their holdings. In some cases, it is impossible.

A paradox is, therefore, that ESG seems to flourish most in liberal democracies with a vigorous media, noisy politics and an engaged investing public. And yet the most deserving targets of their ESG ire may be in far less open, accountable countries. To some degree, then, the limits of ESG will be shaped by political, not just economic, considerations.

The world has moved quite a way since the late Professor Milton Friedman argued that focusing on anything other than building shareholder value was not just foolish, but a form of theft. It is important to realise that even in a classical liberal world that Friedman would have favoured, there would be nothing to stop a businessman or woman who founded a firm to want it to bring about specific values other than just financial results. There are plenty of gung-ho capitalists who might want to do something other than just make lots of money. It is their money after all. Owners of a firm can demand that it should do what it likes as long as it is within the law. And, as we see, more and more business owners, such as wealth management clients, want to deploy capital to bring about change and sleep with a clear conscience.  

Over time, more information will emerge on how well ESG-themed investments perform. A sharp recession, or dramatic change in technology and politics, may be the test that this area needs. And if the approach emerges without too many bruises, ESG will endure.