Australian firm Research IP has called out rising risks in index-based responsible investment strategies in a new report published this week.
The Research IP study says the rush of money into passive products tracking environmental, social and governance (ESG) themes raises several red flags.
“We are currently witnessing a phase of increased interest in responsible investing,” the report says. “Similar to technology, this is a thematic, and with it comes new funds and new strategies to capitalise on the interest. This is where we, as investors, need to be careful. Is it simply greenwashing? Or a sales pitch to raise funds under management?”
Investors should be wary of index-based ESG funds given the many “challenges” in the data backing the product benchmarks, according to Research IP.
“When constructing indices or passive structures, the size of the universe is also critical. Concentration and liquidity of an index must be evaluated,” the report says.
Furthermore, the Research IP paper says despite a solid 10-year plus period of ESG-based thematic fund outperformance, investors need to question the basis and sustainability of the trend.
“There are vast amounts of money moving into this thematic which helps support performance, but also, these strategies tend to invest in more asset-light technology type businesses, and avoid the old world economy. This broader thematic has been performing very well itself for the last 10+ years,” the report says. “After 30+ years of bond compression, as the cost of capital starts to rise again, do some of these business models begin to be challenged?
“So, is this performance persistent? Is there alpha in the opportunity set, or is ESG simply a subset of a broader quality measure?”
Investors also need to dig deeper to understand the strategic objectives of responsible-labeled thematic funds, considering factors such as index outperformance targets and screening policies.
On balance, Research IP says “just like fixed income (bond) investing we certainly lean towards active implementation in this [ESG] space”.
The report – titled ‘Navigating managed funds: beneath the surface of responsible investing’ – is aimed at providing investors with a detailed update on the state of play in the ESG sector.
As well as outlining the many parameters used to assess fund manager responsible investment claims, the Research IP paper notes financial advisers will also have to stay on top of ESG trends.
“Financial advice is generally principles based, so advisers need to assess if ‘suitability’ includes taking account of non-financial factors, and how these may fit a client’s values,” the report says. “Advice must be suitable and an adviser must have reasonable grounds for the advice. If the advice includes a comparison of managed fund products, an assessment of each managed fund should be undertaken.”
Research IP is due to host its annual NZ fund manager awards early in December – online only – with a responsible investment prize up for grabs.
The fund research business, headed by Darren Howlin, also includes investment director, Oliver Trusler, and Andy Mahony as its sole NZ-based consultant.