Dec 11, 2020
Only a few years ago, investment funds embedding sustainability (or ESG, "Environmental, Social, Governance") criteria in their investment process were a small subset of the global fund industry - not to say a niche market. Investors into ESG-labelled products were ready to take a hit on potential returns in exchange for the satisfaction of having an investment portfolio aligned to their ethical principles.
From a niche market to a new "Gold Rush"
In just a couple of years, the consumer demand for ESG compliant products and services has risen dramatically. This demand is driven among others by the rise of a younger generation (so-called "Gen Y" and "Gen Z") among clients of asset and wealth managers. Simultaneously, some regulatory initiatives slowly emerge, such as the Action Plan on Sustainable Finance adopted by the European Commission in March 2018. This combination has rapidly propelled ESG offerings to the forefront in the past 18 months.
The most recent data points reinforced this trend. Interestingly, a number of Morningstar publications suggest that most funds labelled as "ESG compliant" outperformed comparable conventional funds not only in 2019, but in average also over the past years. Others indicate that these funds also resisted better in 2020, at least so far, to the COVID-19 crisis than their conventional peers. Press coverage has followed, with an increasing amount of publications dedicated to praising what appears to be an amazing performance over the last months. Time will tell if this good performance is a short term phenomenon or a longer term trend. But the matter is anyway elsewhere - it is about principles, not only figures.
In parallel, inflows into ESG-labelled funds have hit records. As per Morningstar’s Global Sustainable Fund Flows report, in the second quarter of 2020 only, these funds attracted inflows of 71 billion dollars, bringing the whole industry of ESG-labelled investment funds to a record level of 1 trillion dollars assets under management by mid-2020.
In no time, ESG has moved away from being the branding of a handful of products attracting a niche clientele ready to compromise on revenues. It has become a mainstream offering, which asset and wealth managers have to have on their product suite if they want to remain relevant. Instead of being synonym of reduced margins, it has become the new golden goose.
It seems likely that this "ESG Rush" is just starting. Product manufacturers are already multiplying the number of ESG-labelled products, and trying to move whole product suites under ESG labels. Before long, compliance with predefined ESG frameworks will be an integral part of the investment process of most, if not all, products offered by asset and wealth managers.
Most miners in the 19th century found only mud and pain
This newborn passion of sellers and buyers for investment products claiming compliance with ESG principles should however be regarded with some caution and reservation.
Regulatory guidance on what ESG compliance should entail is almost inexistent. Commonly accepted industry standards are also missing. Financial services companies have therefore to design in-house their own ESG frameworks, and answer questions such as: which criteria to consider behind the "E", the "S" and the "G" dimensions of ESG compliance? How to weight these criteria? Where to gather the information from? How to reflect these data points into a quantifiable scale, and which type of scale?
Because nothing guarantees that these frameworks will be consistent or comparable, it is likely that ‘ESG compliant’ will mean very different realities from one financial institution to another in the next couple of years, triggering some consumer confusion on what they are actually buying and investing into.
Particular attention, and possibly concerns, should be granted to the timeframe in which these frameworks get developed, in order to respond to the revenue opportunity of ESG labelling. The temptation to take shortcuts due to time-to-market constraints is there. Most of in-house ESG frameworks in the financial industry are based on exclusion criteria, still relatively simple and generally relying on publicly available data sources, such as MSCI ESG indexes. One may wonder whether the portfolios currently labelled as "ESG compliant" are actually significantly different from conventional portfolios, or whether they simply undergo some light filtering to what may or may not be included into the portfolio – possibly with limited impact on the final portfolio.
The rapid development of ESG labelling by asset and wealth managers therefore bears the risk of a mismatch between what they communicate to the public, and their clients, and what they actually do. In its worst form, this mismatch is called ‘greenwashing’.
Regulators and control functions will be critical for the sake of ESG labelling
For regulators and all control functions, it is time to be bold. The lack of regulatory requirements to test against, the limited maturity (sometimes the complete absence) of internal policies should not be seen as an obstacle to monitoring and testing.
Communications to the public, typically via marketing materials, attract clients who sign up based on certain expectations. It is the control functions’ mandate, one could say mission, to ensure that asset and wealth managers do actually live up, in their investment processes, to the commitments made in their communications and publications. Setting high standards from the start, despite nascent regulation and policies, is critical to ensure that, in the interest of all, we commonly build this emerging industry on solid and sustainable grounds.
From a niche market to a new "Gold Rush"
In just a couple of years, the consumer demand for ESG compliant products and services has risen dramatically. This demand is driven among others by the rise of a younger generation (so-called "Gen Y" and "Gen Z") among clients of asset and wealth managers. Simultaneously, some regulatory initiatives slowly emerge, such as the Action Plan on Sustainable Finance adopted by the European Commission in March 2018. This combination has rapidly propelled ESG offerings to the forefront in the past 18 months.
The most recent data points reinforced this trend. Interestingly, a number of Morningstar publications suggest that most funds labelled as "ESG compliant" outperformed comparable conventional funds not only in 2019, but in average also over the past years. Others indicate that these funds also resisted better in 2020, at least so far, to the COVID-19 crisis than their conventional peers. Press coverage has followed, with an increasing amount of publications dedicated to praising what appears to be an amazing performance over the last months. Time will tell if this good performance is a short term phenomenon or a longer term trend. But the matter is anyway elsewhere - it is about principles, not only figures.
In parallel, inflows into ESG-labelled funds have hit records. As per Morningstar’s Global Sustainable Fund Flows report, in the second quarter of 2020 only, these funds attracted inflows of 71 billion dollars, bringing the whole industry of ESG-labelled investment funds to a record level of 1 trillion dollars assets under management by mid-2020.
In no time, ESG has moved away from being the branding of a handful of products attracting a niche clientele ready to compromise on revenues. It has become a mainstream offering, which asset and wealth managers have to have on their product suite if they want to remain relevant. Instead of being synonym of reduced margins, it has become the new golden goose.
It seems likely that this "ESG Rush" is just starting. Product manufacturers are already multiplying the number of ESG-labelled products, and trying to move whole product suites under ESG labels. Before long, compliance with predefined ESG frameworks will be an integral part of the investment process of most, if not all, products offered by asset and wealth managers.
Most miners in the 19th century found only mud and pain
This newborn passion of sellers and buyers for investment products claiming compliance with ESG principles should however be regarded with some caution and reservation.
Regulatory guidance on what ESG compliance should entail is almost inexistent. Commonly accepted industry standards are also missing. Financial services companies have therefore to design in-house their own ESG frameworks, and answer questions such as: which criteria to consider behind the "E", the "S" and the "G" dimensions of ESG compliance? How to weight these criteria? Where to gather the information from? How to reflect these data points into a quantifiable scale, and which type of scale?
Because nothing guarantees that these frameworks will be consistent or comparable, it is likely that ‘ESG compliant’ will mean very different realities from one financial institution to another in the next couple of years, triggering some consumer confusion on what they are actually buying and investing into.
Particular attention, and possibly concerns, should be granted to the timeframe in which these frameworks get developed, in order to respond to the revenue opportunity of ESG labelling. The temptation to take shortcuts due to time-to-market constraints is there. Most of in-house ESG frameworks in the financial industry are based on exclusion criteria, still relatively simple and generally relying on publicly available data sources, such as MSCI ESG indexes. One may wonder whether the portfolios currently labelled as "ESG compliant" are actually significantly different from conventional portfolios, or whether they simply undergo some light filtering to what may or may not be included into the portfolio – possibly with limited impact on the final portfolio.
The rapid development of ESG labelling by asset and wealth managers therefore bears the risk of a mismatch between what they communicate to the public, and their clients, and what they actually do. In its worst form, this mismatch is called ‘greenwashing’.
Regulators and control functions will be critical for the sake of ESG labelling
For regulators and all control functions, it is time to be bold. The lack of regulatory requirements to test against, the limited maturity (sometimes the complete absence) of internal policies should not be seen as an obstacle to monitoring and testing.
Communications to the public, typically via marketing materials, attract clients who sign up based on certain expectations. It is the control functions’ mandate, one could say mission, to ensure that asset and wealth managers do actually live up, in their investment processes, to the commitments made in their communications and publications. Setting high standards from the start, despite nascent regulation and policies, is critical to ensure that, in the interest of all, we commonly build this emerging industry on solid and sustainable grounds.
Romain Leroy-Castillo