ETF industry thought leader explains why lack of empirical truth in ESG puts onus on advisors to get smart
Institutional investors have been paying attention to it for years; a surge in demand and assets last year put it firmly on the map; and this year, it got even more attention with the world’s largest asset manager’s commitment to support a campaign against climate change. With all these developments, the case for financial advisors to incorporate ESG investing in their practice is growing — but there’s one problem.
“An overarching theme around ESG investing is that no two people could even agree what we’re talking about,” Dave Nadig, Director of Research at ETF Trends, told Wealth Professional. A 25-year ETF industry veteran, Nadig was most recently the Managing Director of ETF.com, and he will be one of the keynote speakers at the upcoming WP Invest ESG Conference.
A ‘wild west’ in ESG
Anecdotally, Nadig noted, advisors’ ESG conversations with clients start when they go through estate planning together. When the discussion turns to wealth transfers, the difference in priorities between generations becomes clear: as reflected in countless surveys and analysis of investment fund flows, millennials and the youngest of the Gen Xers tend to focus on responsible investing much more than baby boomers.
For those looking to court the next generation of clients, familiarity with the terrain of ESG can be a valuable asset. But as it stands, the ESG ETF space is a wild west: like factor funds or sector funds, the umbrella of ESG funds can cover products with very different and sometimes diametrically opposed mandates.
“Look up any list of socially responsible funds here in the US, and you’ll find both funds tracking LGBT-positive stocks and Catholic-values funds,” Nadig said. “They’re literally antithetical, but both invest based on social values.”
The simple fact, he stressed, is that there is no empirical truth when it comes to ESG investing. High-quality data, along with improvements in technology, mathematical methods, and disclosure rules, revealed the existence of investment factors, but those factors were already there decades before, just waiting to be discovered. In contrast, ESG mandates boil down to a difference in values.
Those differences can be seen among firms that provide ESG datasets, like MSCI and Sustainalytics. According to Nadig, their methodologies already contain a fundamental opinion, which has important implications for advisors who want to help clients create ESG portfolios with funds based on those datasets.
“Advisors can’t just lean on conventional wisdom,” he said. “Nobody ever got fired for saying that they’re using the definition of emerging markets decided by MSCI, but you can’t say that about ESG.”
Adding value outside alpha
Because values are more critical in the ESG space, the best way to get exposure may not lie in finding a methodology an investor agrees with, but in finding the person or team who share the same values. That means the active-passive battle, which has for years been scored in favour of index-based strategies, may play out very differently among ESG funds.
“ESG has for decades been the province of active managers, including endowments or firms running big, actively managed ESG portfolios,” Nadig said. “It’s not that active managers will necessarily outperform based on their stock-picking ability, but because there’s room for interpretation.”
For example, investors might want to use their dollars to promote lower carbon emissions around the planet. Some would choose to not invest in any fossil fuel companies; others might decide that they still need energy-sector exposure, preferring instead to talk to the boards of those firms and decide which ones are working hard to transform their business models and avoid climate-change risks.
“That’s very tough to bake into an index. Those are human conversations,” Nadig said. “And so here’s a place where active management may not be adding alpha, but it may be adding value in aligning the investor’s portfolio with their interests more clearly.”
That’s not to say that ESG investing doesn’t result in outperformance. According to Nadig, some statistics show herding into the ESG space; within industries, companies with high ESG scores are starting to show statistically significant overvaluation compared to low-scoring companies. And the last year has shown numerous ESG strategies outperforming their non-ESG peers.
“These new ESG ETFs that are launching are chasing the same companies as UN PRI-mandated managers and institutions with tens of trillions of dollars in assets,” he said.
Some critics may contend that it’s all specious outperformance; at the end of the day, companies should get paid based on the revenues they produce. But Nadig is more open-minded: there could be a virtuous cycle where capital markets assign higher valuations to “boy scouts” in the marketplace, who in turn can use the capital raised to build their business and take more steps forward in ESG issues such as environmental action or good labour practices.
“I don’t think we’re there yet, but that’s sort of where the next step is,” he said. “If you believe that capital will start being allocated based on this less economic vector, then it can turn into a self-fulfilling prophecy.”
