Mr. Scarth has drawn attention to on an important and challenging issue in Responsible Investment: important because analysts who fail to integrate material ESG issues into their valuation process may handicap their performance; and challenging because, while the ESG data sources may be inchoate, the ESG integration process is … well, at the end of the day it’s just traditional financial analysis with some additional inputs, and therefore hard to label as anything other than ‘active management’.
The UN backed Principles for Responsible Investment (PRI) mandates two practices for Responsible Investment: first, the integration of material ESG issues into the valuation and selection of securities; and second, active ownership of portfolio securities, in particular engagement with management and the considered voting of proxies on ESG issues. The two practices should combine to help active managers improve risk adjusted returns, though - as Mr. Jones comments - the perennial challenge to active managers remains: the improved performance must outweigh the cost of the new ESG data and active ownership.
The PRI’s definition of Responsible Investment is entirely consistent with the Body of Knowledge covered in the CFA program, and while CFA Institute has partnered with the PRI for several years, the incorporation of material ESG issues into the CFA program has until recently appeared to lag, and the ‘active ownership’ side of the equation still lags. (Ownership has generally been considered through the lens of a ‘control premium’ and not one of ‘shareholder engagement’.)
The challenge to CFA Institute and others is that ESG issues are still identified with the morals-based Socially Responsible Investment (SRI) movement that in turn traces its roots to the screening of ‘sin stocks’ by religious organizations. As Mr. Scarth notes, there is ample literature tracing the evolution of SRI screening (see for example Viviers and Eccles (2012); Schueth (2003); or Domini (1992)). Despite the PRI’s clear practitioner-oriented definition it is SRI’s morals-based approach that is most often associated with ‘ESG investing’ by the general public, and most visibly by fossil fuel divestiture movements on university campuses. Unfortunately, ESG has become a catch-all phrase that updates and replaces SRI.
SRI is clearly a behavioural rather than neoclassical finance approach, and while many investors may quietly align their morals with their stock holdings, it is not hard to find examples of the ‘virtue signalling’ that Mr. Jones decries and that is at odds with Modern Portfolio Theory.
As Mr. Jones also comments, the active and passive managers of Wall Street have seldom shied from opportunity - in this case the opportunity to exploit ESG issues that are both material to investment performance and that resonate with investors’ morals. The ESG issues will align to produce positive alpha in some periods and negative alpha in others, but they will always be available for marketing campaigns and the gathering of assets (and perhaps for annual letters to CEOs).
One of the reasons so many asset managers have signed on to the PRI may be to signal to institutional asset owners their ESG bona fides without needing to espouse a particular (or any) screening approach. The PRI requires an annual filing detailing a signatory’s ESG practices, and while Mr. Scarth notes the challenges in his type of reporting he then falls down a rabbit hole by failing to distinguish between the incorporation of material ESG issues into analysis, and the use of ESG issues for a morals-based investment screen.
Mr. Scarth appears to burrow a bit further when he states that “every aspiring ESG fund asset manager must decide where they will focus and what ESG implementation strategies they will employ and to what proportion”. His wording implies a thematic approach that aligns fund holdings with SDG outcomes, which may align with morals-based marketing campaigns, but which renders secondary issues that most analysts would consider of primary importance: the financial materiality of issues under a framework such as that promulgated by the Sustainable Accounting Standards Board (SASB). (To be fair to Mr. Scarth, his comment does align with the direction the EU appears to be headed with its recent ESG taxonomy work, but my comment would also apply there).
To paraphrase Meir Statman’s recent work, there is nothing wrong with aligning one’s morals with one’s investments - indeed, as Mr. Marthaler comments, it is often part of an advisor’s job - but it mixes two separate goals: optimizing risk-adjusted returns; and feeling good (or at least not feeling bad).
Despite these quibbles with Mr. Scarth’s article, he does raise an important point. At the end of the day, the integration of material ESG issues into the analysis and valuation of stocks should be a routine part of an analyst’s job (and a central part of the CFA program), but it is difficult to assess managers’ approaches ex ante. If CFA Institute appeared a bit slow on ESG issues, perhaps it is because the analytical tools remain the same - just the ESG issues and inputs are new. For their part, active managers should consider ESG issues as a potential source of alpha, and as an additional cost to be managed.
For a good, high level overview of reporting and impact measurement challenges for ESG issues please see Jennifer Howard-Grenville’s January 22, 2021 article in Harvard Business Review.