There is a significant increase in the number of commentators taking a swing at ESG investing and suggesting that it is neither effective nor in the best interest of investors as it likely puts them at risk of underperformance. The performance piece has largely been a moot point until now as the funds flowing into the ESG space have been high enough to ensure outperformance from a simple supply/demand perspective, see chart below. However, should the flow of funds slow and investments be judged on their own merits many fund managers are going to find that they own some egregiously expensive stocks with fundamentals that do not support the valuation. If this then leads to a rotation out of a sub-set of names, the future outperformance of the class is far from guaranteed.
Our meetings over the last couple of weeks confirm several developments within the ESG investing world, all of which have been the focuses of our prior work. The first is a very significant step up in ESG oversight among most fund managers, with dedicated ESG teams at many companies scrutinizing sustainability reports and other releases, looking for red flags either from inconsistencies in reporting or from departures from the fund managers standards. Second, there remains a lack of real empirical analysis that allows for accurate comparisons between companies and this stems from the fuzzy reporting frameworks that we have today and the lack of clear and actionable guidance from regulators. As we have discussed several times, the huge inflows into ESG funds and the proportion of overall funds market that now has a “social impact” overlay could lead to real disruptions and some rapid valuation changes if and when the regulators provide tighter guidance on both corporate reporting and fund labeling.