Pecuniary investments for a pecuniary world

13 Sep 2022 | The GOP hates ESG; BlackRock hits back; untangling ESG and impact (again).

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🦅 Whose ideological agenda is it, anyway? In recent weeks, Virginia, Idaho, and Oklahoma have outlined policies to punish ESG investors, while Texas moved to ban 10 asset managers — most notably BlackRock — from managing state investments, because what better way to signal your distaste for boycotting than to boycott the boycotters? In any event, BlackRock doesn’t see itself as one, pointing to its $100B allocation to Texas energy companies as proof. That shouldn’t be news to anyone who read CEO Larry Fink’s January letter to shareholders, in which he stated the firm “does not pursue divestment from oil and gas companies,” but it wasn’t enough to placate the 19 Republican state attorneys general who, last month, accused BlackRock of sacrificing its fiduciary duties. More recently, Florida governor Ron DeSantis blocked state pension fund managers from incorporating ESG factors into their investment decisions. The new resolution requires state administrators to rely “only on pecuniary factors,” otherwise defined as a factor “expected to have a material effect on the risk and return of an investment.” Rings a bell.

⚖️ Last week, the Empire clapped back. BlackRock confronted red state “misconceptions” in a letter of its own, defending its climate policies as being “entirely consistent” with its fiduciary obligations. That implies one of two things: Either, climate action is synonymous with financial returns; or, those “climate policies” exist only to the extent they support financial returns. BlackRock appeared to take the safer route, writing that it does not “dictate to companies what specific emission targets they should meet,” and that end investors — including state pension schemes — have the final say on how to vote on their shares. It’s “a line that understates the huge influence that BlackRock wields through its voting decisions and engagement,” writes the FT’s Simon Mundy, and one that sidesteps the uncomfortable debate at the heart of all this. It may be that there’s a “perfect match” in environmental and financial objectives, but what about when they diverge? The question of whether climate action is ‘homework or an extra-curricular activity’ is one with which the ECB, facing double-digit inflation, is now grappling.

🚩 To what extent are any “misconceptions” a beast of the industry’s own making? The problem — which we discuss a lot (most recently in WealthBriefing), as have, lately, Matt Levine and Stuart Kirk — is that ESG has two very different meanings. One frames ESG as risk management, with E + S + G factors, or inputs, that provide clues about the potential risk-adjusted returns of an asset. The other characterises ESG as impact investing, with E + S + G objectives, or outcomes, to be achieved. In smoother markets, when ‘doing well was doing good’, it was tempting to sell the former as the latter — presumably because the ‘iShares ESG Aware MSCI USA ETF’ sounds cooler than the ‘iShares Pecuniary Factors Aware MSCI USA ETF’. Unfortunately, however, it created the distrust death spiral, as we titled events back in May. Which goes something like this: 1. ESG marketing machine implies ESG = impact. 2. Success! ESG goes mainstream. 3. Backlash! Investors branded ‘out of touch’ (GOP); ESG, “a scam” (Elon Musk). 4. People, once again, feel alienated from the finance industry. 5. ESG and impact risk being tossed with the bathwater.

Time to get real

This is an abridged version of an article for ETF Insider, the magazine issued by ETF Stream.

It’s been a turbulent year in the world of sustainable investing.

A series of high-profile greenwashing scandals rocked trust in its providers. The speed with which index providers responded to Russia’s invasion of Ukraine prompted criticism about its efficacy. And the ensuing debate about weapons and fossil fuels in portfolios called into question its very definition.

Yet client demand has remained resilient. Sustainable funds attracted US$32.6B in Q2, holding up better than the broader market. In Europe, those figures are expected to grow on the back of the new MiFID II obligation requiring fund managers to take clients’ sustainability preferences into account.

As the worst effects of climate change are felt across the world, and an emerging generation of retail investors makes their values known, expect more interest in products that meet sustainable objectives.

Treading carefully

Nevertheless, fund providers are wary. Morningstar found just 45 funds were repurposed in Q2: the second-lowest number in three years. Caution is understandable. For a long time, there were no rules mandating the contents of a sustainable fund. Recent investigations levelled at industry behemoths, however, signal those days are over.

A multi-million dollar fine is not the only cause for concern. A year ago, there was less fluency around sustainable investing. Today, customers, journalists, and third-party data providers are scrutinising portfolios independently. Fund providers face mounting pressure to provide clarity about what, exactly, ‘sustainable’ means and achieves.

For products hooked around a clear theme, such as clean energy, it’s a straightforward task. For those with the dubious ‘ESG integration’ moniker, however, it becomes more complicated. Unsurprising, then, that Article 8 funds have fallen out of favour among fund providers, whereas Article 9 funds have not. The scope for Article 8 funds is too vague.

A framework for communicating products will help mitigate risk. So too the CSRD, due in 2024, with which asset managers can, more confidently, build products that do what they say on the tin. As pointed out by BNP Paribas, however, “the order of the regulations could have been better. If, first companies disclose their ESG data… asset managers could use them in the construction of [funds], and finally, distributors could assess investor preferences for sustainable investments.”

50 shades of greenwash

In the meantime, some pitfalls are easy to avoid.

Citing ‘consideration’ or ‘integration’, without reporting on how factors have been considered or integrated, is one. Selling as ‘sustainable’ any product that hugs an index is another. And conflating ESG risk assessments with ‘sustainable’, ‘green’, or ‘ethical’ investment objectives is an open invitation to criticism.

Pending clarification about corporate disclosures and product labels, calls to unbundle ‘ESG’ are gaining ground. Each letter represents a distinct concept with disparate, sometimes conflicting, objectives. Lumping them into a catchall acronym obscures inevitable tradeoffs. What’s more, companies may be incentivised to counterbalance weakness on one metric with an unrelated initiative.

Working at the intersection of finance and machine learning, we often hear the phrase “if you can’t explain it to your grandmother / six-year old / dog, then you don’t understand it.” Asset management needs a similar guiding principle. If you cannot explain to a non-financially literate observer why a sustainable fund is sustainable, it is, perhaps, not.

Self sabotage is systemic

Eschewing clarity, whether wilfully or not, is a dangerous game. Not unlike emissions, the real risk isn’t isolated to individual companies. It’s system-wide.

Already, marketing greenwash has been weaponised. The little white lie — that ESG ratings, and the ESG indices they underpin, have a relationship with social and environmental outcomes — has been taken at face value by the GOP, and sustainable finance made the unlikely target of its campaign vitriol.

MSCI’s “Better portfolios for a better world” walked, so that Elon Musk’s “ESG ratings make no sense” could drive, so that Ron DeSantis’s “Corporate power has been utilized to impose an ideological agenda on the American people through the perversion of financial investment priorities under the euphemistic banners of environmental, social, and corporate governance and diversity, inclusion, and equity” could soar, like a big bald eagle.

To paraphrase Stuart Kirk: ESG carries two meanings. Both have value. To bury clarity about the function of each on its own terms, however, is to bury meaningful debate about — as well as the future of — any version of sustainable investing.