As assets flow to ESG investing, investors on the sidelines face hidden risks

ImpactAlpha, April 17 – Client demand for investments that take into consideration environmental, social and governance factors has big asset managers touting their ESG offerings as a way to reduce downside investment risks.

But if ESG investing lowers risks, the inverse must also be true: portfolios not screened for ESG contain undisclosed and uncompensated risks. That confronts leading asset managers that have embraced ESG investing with an uncomfortable question: Are they exposing the majority of their clients to hidden risks?

In a raft of recent reports, asset managers from giants like BlackRock and State Street to sustainability specialists Boston Common and Cornerstone Capital Group have shown that considering ESG can help reduce investors’ exposure to climate change, supply-chain disruptions, management scandals and other material risks. (ESG funds are also notching outperformance in returns.)

Making the ‘S’ in ESG stand for ‘Share the Wealth’

“We believe ESG is a risk mitigator and an alpha generator,” Rakhi Kumar, head of ESG investments at Street Street Global Advisors told ImpactAlpha. Of State Street’s $2.5 trillion in total assets under management, about $179 billion, or 7%, are managed with ESG considerations.

Agrees Boston Common Asset Management’s Geeta Aiyer, who has built the sustainable investment manager to $2.6 billion in assets under management since 2003: “We can get better growth and are not exposed to the same risk.”

At Good Capital Project’s Total Impact conference in Philadelphia next month, Aiyer, along with State Street’s Lori Heinel, Nuveen’s Peter Reali and other asset managers will explore the question: shouldn’t all investments be assessed for environmental and social risks? (Disclosure: ImpactAlpha is a media sponsor of the Total Impact conference.)

Repricing events

Sustainable and ESG assets represent a growing share of portfolios for both asset owners and managers. But most investors remain unaware. A survey from BNY Mellon’s Newton Investment Management found that 55% of American investors are unfamiliar with “social investment” including ESG and the broader category of responsible investing.

Rising risks may serve to increase investor awareness. The Global Thematic team at the $192 billion Lazard Asset Management, for example, says evolving consumer attitudes, technology disruption and shortfalls in productive reinvestment represent rising “relationship risks” that can undermine a company’s societal license to operate.

“We believe the breakdown of these relationships represent a threat to long-term fundamentals and ultimately returns,” write Lazard’s Steve Wreford and John King.

Climate reality bites investors with PG&E ’s bankruptcy

Climate change may represent an even clearer risk. The global consultancy Mercer last week highlighted the risk of sudden climate-risk “repricing events” that could upend portfolio values. BlackRock suggested investors still are discounting climate risks lurking in their portfolios in assets including municipal bonds, commercial real estate and U.S. utility stocks.

ESG investors, for example, largely avoided the climate-fueled wildfire bankruptcy of California utility PG&E, which warned investors repeatedly of the risks of climate-related disasters. Of the roughly 1,200 sustainable equity funds tracked by Bloomberg, just 34 held shares of PG&E.

A growing body of evidence suggests income inequality influences the universe of risks and opportunities facing investors. So too with the lack of diverse and inclusive executive teams and workplaces. As perhaps the first among equals, the ‘G,’ for good governance, can forestall excessive executive compensation schemes, sinking employee morale and even sexual harassment damage claims.

Simply reverse-engineering the data in such analyses and the conclusion is clear: There are mispriced risks lurking in portfolios totaling trillions of dollars.

Transition challenges

To be sure, the practice of ESG investing is still being developed. The quality of data on the ESG performance of companies varies widely, making comparisons and benchmarking difficult.

More than 125 ESG data providers now serve the market. Even for the same company, their ratings can vary widely, according to State Street. A study of four leading data providers found a correlation of only 0.53 among their scores, “meaning that their ratings of companies are only consistent for about half of the coverage universe,” Kumar and State Street’s Ali Weiner in “The ESG Data Challenge.”

The Impact Alpha: Agents of impact start to infect their hosts

“Our hand is strengthened by ESG data and financial analysis,” says Boston Common’s Aiyer, who says active managers can augment third-party data, and even disagree with ratings. Incomplete information puts a premium on the manager’s judgement, bolstering the case for active management. “Inefficiency is a good thing,” she says. “This is a market inefficiency we can take advantage of.”

An even more fundamental constraint is the nature of passive investing itself. Asset managers are constrained by the dominant indexes, which guide allocations of many large mutual funds and exchange-traded funds.

“The trouble is that even as investors become more concerned about the social and environmental impact of their investments, they’re forced to invest in everything, including companies that make weapons or treat the environment poorly,” Morningstar’s Jon Hale told Barrons recently.

In response, a growing number of ESG or thematic indexes are emerging, with varying levels of depth and rigor. Last week, S&P Dow Jones launched a sustainable version of its S&P 500 index. The new index will seek to maintain the risk and return profile of the S&P 500, but screen out weapons and tobacco companies, as well as companies with low scores relative to the United Nations Global Compact principles. UBS has launched an ETF linked to the S&P 500 ESG Index.

Join the conversation. State Street’s Lori Heinel, Boston Common’s Geeta Aiyer and Nuveen’s Peter Reali are on the agenda at Total Impact Philadelphia. Hosted by the Good Capital Project in collaboration with ImpactPHL, Toniic, Wharton Social Impact Initiative and Intentional Endowments Network, the conference returns May 1-2. ImpactAlpha is a media sponsor. Register with code “ImpactAlpha250” to save $250 (and take advantage of today’s flash sale to save a total of $450).