ESG Is Just A Framework, Not An Investment Philosophy

Investors, the trade and popular press, as well as regulators, have engaged in significant debate among a very long list, about the following:

  • what constitutes environmental, social and governance (ESG) investing,
  • whether assessing companies using such an approach appropriately aligns risks and returns,
  • whether allocating capital based on ESG factors results in the desired outcomes,
  • what the balance between the E, S and G factors should be,
  • which definitions, measurement methodologies and approaches are the most appropriate for a given set of investors
  • what ESG risk ratings mean, how the compare and what do they tell investors

While meritorious, these debates presume the ESG labels are the correct starting point.  ESG emerged from the United Nation’s (UN) attempt to coalesce a multilateral agreement around a set of principles and corporate values to achieve sustainability goals.  Principles and values-based approaches by definition provide flexibility in application and are desirable, because best-practice or rules-based approaches may not be “best” or even desirable in all scenarios nor may they be practical. 

One outcome from this long-term UN effort to provide definition and clarity is an emerging coalescence around how to provide meaningful, verifiable, comparable and disclosable measures.  Naturally, the results align to the UN’s foundational framework, which makes it easier for companies, investors and regulators to have a consistent dialogue and baseline understanding to form a debate.

What investors tell us

In practice, ESG investing is an easy way to market product and signal a “do good” position, but in practice do investors want a generic, vague approach?   In recent analysis, Edelman concluded that approximately 66% of consumers decide on a brand based on social or political issues.  According to Morgan Stanley in 2019, 85% of individual investors and 95% of millennial individual investors said that they want their portfolios to make a positive impact on society.  Our work with advisors indicated that individuals are not focused on the core ESG debate areas listed above; they are not return maximizing.  Most advisors and their clients are focused on achieving financial planning and long-term savings goals.  They also have fundamental beliefs and ethics that may diverge from the broad, standard ESG assumptions or approaches.  As we noted in prior posts, more standard ESG disclosures negate the need for third parties to tell investors what they should think about ESG, i.e. ratings and pre-determined investment philosophies have more limited relevance to the individual investor. Consequently, wealth advisors and industry participants should move away from ESG labels and toward a better understanding of their clients’ values. 

No need to disrupt the framework: implement better

The UN and global reporting frameworks are built on well-defined categories and subcategories that provide a solid foundation from which an advisor can understand their clients’ views and report their values alignment within the context of the clients’ planning and goals.  Simply querying about values is not sufficient.  The advisors must understand HOW important something is to the investor, as well as HOW MUCH impact a change will affect financial plans and goals.  These trade-offs and optimizations are important to communicating portfolio changes, as well as whether such shifts are advisable given the potential to influence an outcome or goal.  Advisors and investors have to balance between their investment goals and their values. 

In the instances where the investors’ values do not outweigh the potential for an investment to help the investor meet a critical financial goal, the investor can still use the power of proxy voting to influence the company’s behaviors.  Although retail investors and their advisors have in recent history not engaged in proxy voting, their relative importance in this vital corporate governance activity (insert link to prior blog) may be changing.  Voting proxies in accordance with values provides a backstop and an action point, where retail investors can voice opinions without divesting or creating the potential to meet targets.   

The bottom line: the investment process starts with understanding highly-specific values not focusing on generic labels.