The inauguration of Joseph Biden’s administration is anticipated to supply significant momentum to environmental, social and governance (ESG) fund products within the United States and speed up their already rapid growth.
Under the outgoing administration of Donald Trump, the U.S. Department of Labor (DOL) amended the Employee Retirement Income Security Act (ERISA) to explicitly prohibit pension administrators from considering ESG aspects when choosing investments and managers, despite the objections of many industry participants.
The recent administration is more likely to lift this ban shortly, opening the door to a possible proliferation of latest ESG products introduced through the 401(k) channel and the separate mandate market.
US managers have been slower to leap on the ESG bandwagon in comparison with their European counterparts. How can they catch up?
Active managers have seen significant growth within the ESG investing segment, particularly in equity and glued income funds. To capitalize on this growth, asset managers can be under pressure to show that their commitment to ESG integration goes beyond superficial lip service. They might want to show that they’ve fully integrated ESG principles into their investment processes.
As the ESG category has grown rapidly, so have allegations of “greenwashing.” Some funds labeled “ESG” only nominally take these facets into consideration. In Europe, regulators have responded by introducing ESG reporting requirements from 2021 to be certain that the labels are accurate.
In the US, the SEC has not given such a high priority to detailed reporting. But investors themselves, especially institutional asset managers and advisors, will demand evidence that the ESG label is greater than only a “shell”.
This is a key challenge for asset managers. In many cases, ESG teams have operated in relative isolation, separate from traditional fundamental investment teams. They must support multiple products, each specialized ESG funds focused on climate change, clean energy, etc., and as an overlay for non-specialized funds. Integrating ESG principles into the latter category may require traditional fundamental investors to adopt recent analytical frameworks.
In addition, ESG research tools are more diverse and complicated than the research inputs of traditional strategies. They include databases, research from investment banks and independent research providers, proxy advisors, sentiment trackers, web scrapers and all forms of specialists that reflect the range of activities and goals of the United Nations (UN) 17 Sustainable Development Goals (SDGs):
UN Sustainable Development Goals (SDGs)
Given the broad scope that these SDGs cover, each emerging ESG fund manager must determine what to give attention to and what ESG implementation strategies to make use of and to what extent.
ESG implementation strategies
The first ESG funds were primarily exclusionary in nature, avoiding corporations linked to tobacco production, weapons manufacturing, carbon energy, etc. But ESG has evolved to incorporate more nuanced approaches, including investing in corporations which can be taking energetic steps to realize these SDGs and dealing with management.
Consequently, the way in which asset managers implement ESG integration research throughout their investment processes can be a function of the ESG strategy decisions they make. The following diagram summarizes these decisions:
Part of the combination process should address how and to what extent different funds use ESG research inputs. In the long term, the excellence between ESG and non-ESG funds will blur.
Evaluating ESG research is especially difficult because managers use a wide range of ESG approaches and implementation strategies, and key ESG research outputs – similar to databases – don’t lend themselves to counting documents or interactions.
This raises three key questions:
- How can managers evaluate ESG research inputs given their specific ESG process, the variety of inputs (data/documents, etc.) and on the fund or client level?
- How can managers show to clients and other stakeholders that ESG is integrated into their broader research process?
- How can managers determine whether additional spending on ESG research must be done internally or externally?
An ESG research assessment process is required that may complement the manager’s existing research assessment methodology in order that ESG research inputs might be assessed based on the manager’s ESG product and implementation approaches. This process must also show how these approaches are applied across all the manager’s funds.
This can then be supplemented by benchmarking research expenditure.
Managers who can show this to asset owners and advisors are well positioned to capitalize on the expansion opportunities ESG offers.
For further insights into ESG integration, please visit FrostConsulting.
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Photo credit: ©Getty Images / Gabriel Shakour
