In recent years, investors have become increasingly concerned about the social impact that their investments may have.
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In 2018, nearly $12 trillion was under the control of money managers who claim to incorporate information about companies’ environmental, social, and governance (ESG) practices into their portfolio selection. (For example, an ESG-oriented money manager may consider a company’s carbon output, the percentage of women on its board of directors, or CEO pay ratio when deciding whether or not to invest.) That number is up 44 percent from 2016 and more than double the 2014 total.
However, with this rapid growth has come increased scrutiny. After all, it’s easy enough for money managers to attract socially conscious investors by advertising a fund as ESG-oriented—but what if some of these managers aren’t putting their funds’ money where their mouths are? In December, The Wall Street Journal reported that the Security and Exchange Commission had contacted some investment firms with ESG options to ask about their decision-making models, presumably to vet the truth in ESG advertising.
Aaron Yoon, an assistant professor of accounting and information management at the Kellogg School, wasn’t surprised by this step from the SEC. The former Credit Suisse trader and quantitative analyst has come to suspect that the ESG investing space may be ready for closer oversight.
But Yoon is hardly an ESG naysayer. In fact, his prior research is widely credited with helping to legitimize certain ESG strategies as lucrative. He’s critical, in other words, because he believes the industry can do better.
“As one of the biggest proponents of ESG, I really want people to get it right,” says Yoon.
Yoon’s latest research, with coauthor Soohun Kim, an assistant professor in the Georgia Institute of Technology’s Scheller College of Business, investigates whether companies that make public ESG commitments truly shift their portfolios towards more socially responsible companies. Yoon and Kim find that though funds typically enjoy a large influx of cash after publicly signing on to a prominent set of ESG investment principles, they become no more ESG-friendly in the following quarters than they’d been previously.
What’s more, after making the public commitment, fund managers were actually less likely to exercise their rights as shareholders to vote on environmental issues presented by the companies in their portfolios. They also increased their investments in companies facing environmental controversies after signing on.
The researchers do find that a specific subset of funds improve their ESG measures post-commitment: those with a history of outperforming the market. Yoon suspects this connection may be explained by the exceptional skills of this group of investment managers—both in generating high returns and in defining smart ESG investing strategies.
Taken as a whole, however, Yoon finds his results discouraging. “It’s a wake-up call,” he says. “There’s a tremendous amount of money [in ESG], but asset managers have been slower than we thought to incorporate ESG. I think we need to view this phenomenon very critically.”
Quantifying Investors’ ESG Decisions
To measure how a professed commitment to ESG translated into decision-making, the researchers focused on money managers who had signed onto the Principles for Responsible Investment (PRI), an initiative founded by the United Nations in 2005 to encourage responsible investment. By signing onto the PRI, these managers publicly committed themselves to adhere to six responsible investment principles, such as pushing for ESG data disclosure from the companies in which they invest and encouraging wider adoption of responsible investment practices in their industry.
The PRI Association offers its signatories resources like research reports, a collaboration portal, and various gatherings meant to support the adoption of more responsible practices. But in order to access these resources—and get their name on a public list of signatories—the CEOs of investment firms must commit to the six principles, report annually on their own responsible investing activity, and pay an annual sliding-scale fee of between roughly £1,000 and £14,000.
“There’s a tremendous amount of money [in ESG], but asset managers have been slower than we thought to incorporate ESG. I think we need to view this phenomenon very critically.”
As of April 2019, the PRI signatory list included more than 2,300 investment managers, asset owners, and service providers who collectively oversee more than $80 trillion in assets under management.
Yoon and Kim winnowed down the list to only those UN PRI signatories that were U.S.-based active investment managers (since those who manage passive index funds and ETFs—the majority of signatories—may not have much freedom to actively incorporate ESG, since they have to replicate an entire index). The resulting sample contained just 95 investment managers overseeing 474 distinct funds.
They then calculated an ESG “score” for each fund, by averaging the ESG ratings for all of the companies in its portfolio at a given point in time. For this step, Yoon and Kim drew on analysis from three firms specializing in ESG analysis: TruValueLabs, MSCI, and Sustainalytics. Each uses different techniques to evaluate the relative ESG strength of publicly traded companies. TruValueLabs, for example, uses artificial intelligence to analyze ESG-related news coverage of a firm, while MSCI considers companies’ industry, operations data, and geographic location.
To determine whether signatory managers do indeed “incorporate ESG issues into investment analysis and decision-making,” as they’ve pledged, the researchers compared each fund’s ESG scores in the six quarters before committing to the Principles to their scores in the six quarters after. Their central question: Did funds’ ESG scores change after signing?
The Real Impact of ESG Investing
The researchers found that publicly committing to the principles led to no ESG score improvements for the average investment portfolio.
Even so, signing the PRI did tend to trigger a significant boost in investor interest; investment funds saw a 3.3 percent increase in investor dollars per quarter upon becoming signatories.
It was possible that funds whose overall scores didn’t improve saw no changes because they were already high performers on ESG. However, Yoon and Kim find that the ESG scores of signatories before signing onto the PRI were not significantly higher than those of non-signatories. They also accounted for the possibility that PRI funds whose scores didn’t improve were nonetheless focusing on environment, social, or governance issues in isolation. To test for this, the researchers repeated their analysis after constructing separate E-, S-, and G-specific scores for each fund. Those comparisons, too, failed to yield any differences between pre- and post-signing.
Next, Yoon and Kim counted the number of environmental, social, or governance controversies surrounding each investible company (for instance, an oil spill or a factory explosion that injured workers). They found mixed results: the number of environmental controversies experienced by firms in the investment managers’ portfolios actually increased after they became signatories, while the number of social controversies decreased.
To allow for the possibility that investment managers applied the PRI mandate to their funds in ways too subtle to be captured by comparing before and after ESG scores, Yoon and Kim conducted additional analyses. Comparing PRI signatory funds and non-signatory funds of equivalent size, for example, they found that the signatory funds, in fact, had lower ESG scores than non-signatory funds. Moreover, signatories’ portfolios failed to outperform the S&P 500 on ESG measures as well.
“There needs to be a systemic and harmonized way to measure, quantify, and assess fund-level ESG performance.”
The researchers also looked at an alternative avenue (other than ESG criteria) by which firms might be pursuing their ESG goals: Could PRI-aligned fund managers improve the practices of the companies in their portfolios by using their shareholder powers to vote on relevant issues—for instance, voting to require energy companies to report on their carbon-reduction goals or to mandate that corporations adopt comprehensive workers’ rights policies?
The research didn’t support this hypothesis, either. Yoon and Kim found that managers voted less often on ESG issues after committing to the principles.
Finally, the researchers wondered whether the funds’ increase in investor dollars might come from a factor other than their PRI pledge. Specifically, Yoon and Kim wondered whether the significant cash inflows to funds following their PRI commitment could be explained by an actual increase in investment returns. That is, if fund managers also happened to deliver higher returns after signing onto the PRI, for one reason or another, then perhaps it was this pattern that was attracting more interest from investors.
That’s unlikely, as it turns out: the researchers found that an average fund’s returns actually fell after it made the PRI pledge. Returns in the second, fifth, and sixth quarters after signing were 0.7 percent, 0.9 percent, and 1.1 percent lower, respectively, than the average prior-period returns.
However, despite what it may seem, Yoon says, “our message is not all negative.” His analysis uncovered a subset of investment managers who did appear to make ESG enhancements after PRI commitment: funds that had tended to beat the market in the past did a better job of incorporating ESG into their portfolios after signing onto the Principles.
Yoon presumes that the reason for the correlation is straightforward: those managers who boast stronger returns and also show signs of more ESG integration post-PRI are probably just smarter investors—the select few who are able to do well while also doing good.
Socially Responsible Investing Needs Clearer Standards
Why did the PRI fail to change most investors’ behavior? Likely because there was little accountability for signatories, Yoon says. “The U.N. has the right idea with this initiative,” he explains, “but they can’t enforce it.” Thus, it is possible that some investment managers are reaping the benefits of an empty promise.
What’s more, he says, the lack of an agreed-upon standard for companies to disclose and quantify their ESG performance makes it difficult even for well-intentioned investors to make responsible portfolio decisions and report their progress.
Because ESG disclosure and analysis are voluntary and guidelines are fragmented, Yoon fears that ESG investors are merely taking “baby steps” toward enforcement, even as money pours into the space. “There needs to be a systemic and harmonized way to measure, quantify, and assess fund-level ESG performance,” he writes in the paper.
Yoon expects that a government agency for ESG standards will materialize within the next decade, likely focusing first on requiring certain reporting practices for companies, so that fund managers have the ESG data they need to make investment decisions. This kind of public oversight is critical, he argues, since the benefits of promoting ESG practices—or the costs of failing to do so—will extend well beyond individual companies, funds, or investors.
“From a social-welfare perspective, these issues are a huge deal,” Yoon says.
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