The backward-looking “static” exclusionary approach to sustainable investment is out, “transparent dynamic inclusion” is in, according to a joint study by US value manager, MFS, and political risk think-tank, the Eurasia Group.
A new report summarising a recent series of talks with fund managers, asset owners and academics, says the stellar growth of environmental, social and governance (ESG) has rendered rigid exclusionists obsolete.
Citing figures from the Global Sustainable Investment Alliance (GSIA), the report notes that the sector saw assets under management surge over the five years to the end of 2020 to reach US$35.3 trillion, equating to just over a third of the total market.
But sustainable investment hangs at an “inflection point”, the paper says, after the rapid market expansion “unearthed problems with using the static exclusion approach at scale”.
“For sustainable investing to continue to grow, it must coincide with financial returns. Improving the ESG profile of a portfolio is not the same as having positive impact on the world — it is easier to achieve an ESG-aligned portfolio, but much harder to directly improve the environment and society,” the report says. “Static and backward-looking ESG analysis can lead to exclusions decision on sovereigns or companies that may have a patchy record and need support to grow in a sustainable way. Engaging with sovereigns or companies that would otherwise have been excluded, therefore, has potential to create a longer-term positive impact if the investor can discern a credible pathway.”
Furthermore, current ESG score-based exclusions typically count against many poorer countries – the economies that would benefit most from sustainable investment.
“Asset managers report that ESG considerations in the investment process risk disadvantaging emerging economies in sovereign debt as well. These are the very countries that most need capital to improve the issues for which they are being penalized,” the paper says. “A further issue for an investment framework relying heavily on data-focused ESG scores is the lack of consistent and accurate data, making such scores less of a true reflection of a country’s risk and reward potential.”
Both asset owners and managers need to address the failings of the current exclusion-heavy ESG model that creates sub-optimal portfolios designed around often poorly expressed sustainable investment aims, according to the joint report.
“Not all clients share the same goals, leaving asset managers to balance a diverse set of objectives, including some that are not clearly articulated,” the analysis says. “Financial returns may still dominate, but it is not clear that end clients, often represented by trustees, have understood the potential tradeoffs involved when constraining investment criteria are applied. While clients may want a more ‘sustainable’ portfolio, very few are willing to give up returns to achieve this.”
If sustainable investment is to move beyond simple knee-jerk exclusions, both asset owners and fund managers should pursue “observable and transparent” ESG integration strategies.
“By assessing the goals and outcomes openly and with an honest look at the limitations of each approach, asset managers and asset owners can jointly come to approaches that create the impacts and returns that both are seeking while strengthening the process of sustainable investment,” the report says.
MFS director of fixed income Europe, Pilar Gomez-Bravo, and global head of sustainability strategy, Vishal Hindocha, co-authored the report along with The Eurasia Group global macro-geoeconomics director, Jens Larsen, and climate and sustainability managing director, Shari Friedman.