The advent of the Joseph Biden administration will likely create a significant tailwind for environmental, social and governance (ESG) fund products in the United States and accelerate their already torrid growth.
Under the outgoing administration of Donald Trump, the Department of Labor (DOL) amended the Employee Retirement Income Security Act (ERISA) to specifically prohibit pension trustees from considering ESG factors in investment selection. and managers. despite objections from many industry players.
The new administration will likely overturn this ban in the near term, opening the door to a potential proliferation of new ESG products introduced through the 401(k) channel and into the market for separate mandates.
US managers have been slower to jump on the ESG train compared to their European peers. How can they catch up?
Active managers have seen significant growth in the ESG investment segment, particularly in equity and fixed income funds. To access this growth, asset managers will be forced to show that their commitment to ESG integration goes beyond lip service. They will have to demonstrate that they have fully integrated ESG principles into their investment processes.
Accusations of “greenwashing” have multiplied alongside the rapid growth of the ESG category. Some “ESG” labeled funds only nominally integrate these considerations. In Europe, regulators have responded by imposing ESG reporting requirements from 2021 to try to ensure the accuracy of labels.
In the United States, the SEC has not made detailed reporting such a high priority. But investors themselves, especially institutional asset owners and consultants, will want proof that the ESG label is more than just “wrapper”.
This is a major challenge for asset managers. In many cases, ESG teams have worked in relative isolation, away from traditional fundamental investment teams. They must support multiple products, both specialized ESG funds focusing on climate change, clean energy, etc., and in overlay for non-specialist funds. Incorporating ESG principles into this latter category may require traditional fundamental investors to adopt new analytical frameworks.
ESG research tools are also more varied and nuanced than the research inputs of traditional strategies. They include databases, research from investment banks and independent research producers, proxy advisors, sentiment trackers, web scrapers and all sorts of specialists that reflect the range of business and goals contained in the 17 Sustainable Development of the United Nations (UN). Goals (SDGs):
United Nations Sustainable Development Goals (SDGs)
Given the broad spectrum covered by these SDGs, every aspiring ESG fund asset manager needs to decide what they will focus on and what ESG implementation strategies they will use and in what proportion.
ESG implementation strategies
Early ESG funds were primarily proprietary in nature. They avoided businesses associated with tobacco production, weapons manufacturing, carbon energy, etc. But ESG has evolved to include more nuanced approaches, including investing in companies that are taking active steps to achieve these SDGs and engaging with company management.
Therefore, how asset managers integrate the search for ESG integration into their overall investment processes will depend on the ESG strategic choices they have made. The following diagram summarizes these choices:
Part of the integration process should determine how and to what extent different funds use ESG research inputs. In the longer term, the distinction between ESG and non-ESG funds will blur.
ESG research inputs are particularly difficult to assess because of the variety of ESG approaches and implementation strategies used by managers and because important ESG research inputs — databases, for example — do not do not lend themselves to documenting or counting interactions.
This raises three key questions:
- How can managers assess the contributions of ESG research given the manager’s particular ESG process? input diversity (data/documents, etc.); and at fund or client level?
- How can managers demonstrate ESG integration in their broader research process to clients and other stakeholders?
- How can managers determine whether additional ESG research spending should be internal or external?
What is needed is an ESG research evaluation process that can overlay the manager’s existing research evaluation methodology so that ESG research data can be evaluated against the ESG product and manager’s implementation approaches. This process should also demonstrate how these approaches are applied to all of the manager’s funds.
This can then be increased by comparing research expenditure.
Managers who can demonstrate this to asset owners and consultants will be well placed to seize the growth opportunity that ESG offers.
Further information on ESG integration is available at FrostConsulting.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Gabriel Shakour