Director of Responsible Investing at Federated Hermes, leading ESG integration and engagement across $600 billion in global assets.
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Rewind a decade or so. You've decided it's time to eat better, so you head to the local grocery store looking for some healthy options. After strolling down aisle after aisle, you run into the "organic" section. It's tucked away in the back, identified by an unassuming green marker.
Fast forward to today. Step foot in a supermarket, and you are bombarded with signs and labels touting natural cuisine. Organic food is mainstream. But success breeds competition and, with it, products of varying quality and questionable nutritional value.
If ever there is a time to be suspicious of a claim, it's when it becomes a mass-media trend, and this certainly applies to investments.
With capital rapidly flowing into sustainable investing funds, an increasing number of managers are saying they have always integrated environmental, social and governance (ESG) criteria into their investment process. Claiming ESG integration is also becoming mainstream as everyone wants a piece of the growing pie. However, perception is not always reality. To judge any product's legitimacy, you need to take a closer look and understand the quality of ingredients.
Firm Commitment
Global investment managers are not unlike food conglomerates — think asset classes as food types and funds approximating brands. Both even call their offerings "products." If a manufacturer's dedication to natural food only extends to one brand out of many, you'd be wise to ask the obvious question: What's in their nonorganic food? A company that holds out wholesome options with one hand and processed foods with the other might not be fully committed to healthy eating.
It's a similar story with responsible investing. Investors should be wary of firms that parcel out the incorporation of ESG criteria into only a few vehicles but may be remiss to do so in their other funds. A siloed approach may be the symptom of superficial commitment. They are still feeling out consumer demand to see if the so-called Green Wave is itself sustainable. Ultimately, in many cases there may be no intention to integrate ESG into their flagship strategies if they do not see a value add.
Responsible asset management is most successful as a firm-wide mission. It should extend across all asset classes and investment teams and be supported from the board down — not walled-off or in a disconnected division. If an asset manager believes ESG helps mitigate risk and builds long-term wealth for its clients, then the mindset should be to determine how it can be incorporated into the full spectrum of investment solutions.
ESG Expertise
Responsible investing doesn't mean every portfolio manager needs a Ph.D. in biodiversity. They run funds because they know the markets, how to evaluate credit and how to read economic developments. What they need is an ESG informational advantage that they can include in their investment process. That intelligence should be supplied by in-house staff offering relevant sustainability expertise. A leading indicator of how serious a firm is about ESG is its investment in human capital. Does it have ESG subject-matter experts dedicated to engagement, stewardship and responsible investing? If so, are their backgrounds and education steeped in corporate sustainability, environmental data science and social advocacy experience?
Bigger is not always better, of course. How the staff is assigned and the quality of their output means everything. If they spend their time simply regurgitating data from third-party ESG providers and passively writing letters, the result won't be as effective as proactive engagement with a company's board and management on material considerations. For assessing risk and advocating for positive change, there is no substitute for going directly to the source with a subject-matter expert. A climate change specialist is best positioned to have a collaborative dialogue with an oil and gas supermajor about how the company is transitioning its power generation and workforce. When combined with active fundamental analysis performed by an experienced portfolio manager, the outcome is a better understanding of long-term ESG risk and the identification of mispriced investment opportunities.
Proprietary Capabilities
Building a qualified team and fostering a culture are required to align ingredients with what's on the label. Boots on the ground gives a firm proprietary ESG insights as a complement to deep fundamental research. This is the new line in the sand to distinguish authentic versus cosmetic ESG integration. Does an asset manager have proprietary capabilities, or is it simply outsourcing research to an outside vendor? Third-party reports are a useful starting point, but they shouldn't be the primary way portfolio managers and investment analysts inform their environmental, social and governance research. High-touch engagement performed by specialists with expertise in a particular sector is far more robust and leads to a more comprehensive understanding.
Many active managers still outsource the majority of their ESG research and rely on ratings off the shelf. The barrier to entry in this approach is low, and historically many consumers lacked the time or resources to tell the difference. As more passive ESG products emerge all using the same data source, the whole endeavor becomes increasingly commoditized. The market is beginning to examine in-house capabilities, with a gravitational pull toward investment managers with proprietary ESG data analytics and a dedicated active stewardship team.
Ever since novelist Upton Sinclair's The Jungle shined a harsh light on sanitary practices in the meatpacking industry, food safety has come under greater scrutiny. Demand for better reporting on the people, tools and outcomes generated from ESG engagement are on the rise when evaluating a responsible asset manager.
Ultimately, most analogies are a stretch. But the parallels between claims of organic food and sustainable investing do make for an intriguing comparison. Watch what you eat, and how you invest.
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