Here’s why you need to take claims for ESG investing with a big pinch of salt

Investing with environmental, social and corporate governance (ESG) issues in mind is all the rage, and fund managers are jumping on the bandwagon. That means you need to be careful, says John Stepek.

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Back to this morning. ESG funds are having a moment. Funds that invest with environmental, social and corporate governance (ESG) issues in mind had a very good 2020, according to Attracta Mooney and Patrick Mathurin in the Financial Times.

Total assets in these funds rose to nearly $1.7trn last year, up a whopping 50% on the previous year. Given what happened to markets in 2020, that’s extraordinary.

So what’s going on? And what do you need to know about ESG?

The trouble with active management

Let’s start with a bit of background here. It’s been a rough few years for active fund managers. Before passive funds became such a big deal, being a mediocre fund manager was a cushy job: you found a hot sector or company; you bought stocks that roughly reflected the underlying index; you watched the money roll in from punters, or from the people who advised the punters; and you took a percentage fee from that big pile of money.

As long as your performance wasn’t ridiculously bad – and as long as you quietly did nothing more radical than tracking the index, it wouldn’t be – then you could sit on your big pile of money, and not do very much more than run the occasional ad campaign around Isa season to make sure the cash kept defaulting into your big lazy fund. 

Those days are gone. Investors are still saving money – that’s not the issue – the problem is that most of it has been going into passive funds. Investors have realised that by using passive funds (which just track an underlying market, rather than trying to beat it), they can get exposure to markets at a much lower cost than by using active funds.

If active funds compensated for their higher charges with consistently better performance, then this wouldn’t be a problem. It would still make more sense to pay for the added performance. However, finding an active fund that can beat the market consistently is extremely hard. So if you opt for active over passive, you risk not only paying more, but getting a worse performance too. That has turned active funds from being something of the default option to being a much harder sell. In turn, that means the bloated “asset gathering” model is endangered.

What are the options? Reducing fees is one option. Fees generally have gone down – a bit – over time. And we’ve also seen the occasional genuinely innovative fee structure which at least attempt to align the manager’s interests with those of their customers. But you can only cut fees so far. When it comes down to it, an actively-run fund is going to struggle to compete with passive funds that, in some cases, charge absolutely nothing at all.

Another option is just to be better. Some managers are doing this very successfully right now. The investment trust sector has always been nimbler and arguably more accountable to its investors than the unit trust/open-ended funds, and they are having their time in the spotlight right now. 

For example, investment trust and growth stock specialist Baillie Gifford is one of the best known active success stories today. Meanwhile, in the US, Cathie Wood’s ARK Investment is doing well by capitalising on thematic investing. Both have stellar records of trouncing any passive tracker and, as a result, attracted a lot of investors’ money.

So a record of genuine outperformance is another way to stay successful. But it’s not easy to get on top, and it’s even harder to stay on top – even the best fund managers endure tough periods, during which investors’ affections can prove fickle.

Other managers demonstrate a commitment to genuine active investing – having small, concentrated portfolios of their “best ideas” (typically between 20 and 35 stocks). They may also stick very explicitly to a style (such as “value”, for example). Even if they’re out of fashion for a time, at least investors know what they’re getting – no one knows what the future holds, so diversifying your portfolio by style can be as sensible as diversifying by geography and asset class.

But what if being better, cheaper, or more disciplined than everyone else is not for you? What if you just want to attract investor money the old-fashioned way? You know, via a combination of hype and apathy? That’s where ESG funds come in.

ESG is a cynical branding exercise for some

This is going to sound cynical, so let me begin by saying that there are some very dedicated ethical/ESG/sustainable investment groups out there who have been doing this for decades. Ethical investing is not new. Nor is concern about the climate or working conditions or whether you should buy tobacco stocks or not, and all the other issues surrounding ESG investment.

Indeed, interest in ESG investing isn’t particularly new either; it’s not something that millennials invented. So what explains the upsurge in the industry getting interested in it? There are a lot of factors, but at least one big factor is that active managers see an opportunity to fight back against passive that doesn’t involve a) being cheaper or b) being better.

Passive has made inroads into the ESG area too. But it’s a harder sell. The whole point of ESG is that there’s meant to be someone making judgements about the companies involved. An index tracker might be able to do simple ESG screens but it’s never going to be able to “engage” with company managements to the same level.

Also the biggest passive players will always struggle to go “pure ESG” – you can’t claim the moral high ground by launching a carbon-neutral ETF when you’re running a massive S&P 500 tracker on the side with full exposure to all those horrible fossil fuel companies.

So active companies suddenly have a new battleground where they can give investors a reason to use them again. They’ll tackle managements and make sure that they keep the nasty stuff out of your portfolio. And they’ll be able to charge you for it and if performance isn’t up to scratch, then never mind, at least your money is “doing good”.

Think I’m being overly twisted here? I don’t. In Europe last year, more than 2,500 existing active funds rebranded to “ESG”, rather than starting new funds from scratch. I’m sorry, but that’s not a change of strategy or a Damascene conversion – that’s a marketing decision.

ESG will continue to be a force in investing – we’re going to be seeing ever more promises regarding carbon neutrality from governments and from companies, and we’ll keep seeing new reports about how ESG has outperformed (it’s amazing how good you can look when you avoided energy stocks in an energy bear market and stuck all your money in the FAANGs instead – be interesting to see what happens when the turn comes).

I’m just warning you to take it all with a pinch of salt. “Greenwashing” is endemic to this part of the business. If you care about investing in accordance with your ethical beliefs, then you need to do your homework. Understand where your own boundaries are, then find a fund that respects those specific boundaries (remember that some ESG funds hold Exxon Mobil, for example).

If you can’t be bothered doing the homework, then do yourself a favour – don’t stick it in any old ESG fund that you see being marketed to you. Use a cheap passive fund instead. At least you know what’s in it.

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