• Warning signs abound on ESG messaging. Unless fund managers can demonstrate that their ESG investment promises are backed by rigorous processes, they will face backlash.
  • Historical risk focus has to shift to investing proactively. Green bonds, social bonds and stakeholder equity will become a significant source of financing activity – and allow fund managers who mean what they say to put their ESG money to work.
  • The future is impact. Instead of focusing on target returns, investment firms will need to start talking first about the ESG impact of their investment programme.

Telling the truth is important. Anyone in the global investment community who has taken a cynical approach to the ESG movement is starting to be found out. And that is having serious consequences, reputationally and in terms of financial value.

When it emerged recently that DWS, the listed asset management subsidiary of Deutsche Bank, was being investigated by regulators over claims it exaggerated its ESG credentials the news sent its share price tumbling. In the UK, the FRC’s recent stewardship code compliance exercise led to significant press coverage of the asset management firms that did not meet the increased level of scrutiny mandated. Combined, these events are hand warmers for all the ESG sceptics who have claimed for a long time that the asset management sector is overstating its credentials in this area. 

The eventual regulatory impact on DWS is still unclear, and it seems highly plausible the company will be able to mount a robust response. Similarly, the FRC is likely to get much improved submissions from asset managers by its October 31st deadline for amended reporting.

The regulatory scrutiny now being applied to ESG claims is forcing change. Yet I believe these issues point towards a bigger change in the direction of travel in ESG – away from a historical risk focus, and towards a meaningful impact one.

The non-financial issues that ESG analysis typically takes into account have been, for many if not most fund managers, placed in the risk management category for a long time. While the ‘hard’ financial analysis is supposed to guide an analyst in making accurate forecasts of future financial performance, the ‘soft’ ESG analysis is supposed to help her avoid a non-financial issue blowing up her financial model. Avoiding issues such as accounting fraud, consumer boycotts, and social media product backlash all can be seen as successful outcomes of ESG analysis resulting in risk mitigation. 

Now that the fund management industry is focused on the ESG area as an area of business growth – or at least as a defensive play to help fight against persistent outflows from active management products – it needs to evolve the historical approach above. I would suggest this will come from three areas: regulatory and client pressure, capital market issuance, and ultimately a change in the risk/reward paradigm.

The first of the three areas is clear enough from the recent issues faced by DWS and those highlighted by the FRC. Unless fund managers can demonstrate, in both deed and internal records, that their ESG investment promise is backed up by rigorous processes, they will face a backlash. Many firms will no doubt already be able to do just this, and thus avoid being ‘smoked out’ as greenwashers, and more will step up their game given the recent headlines. This will involve more ESG analysis training of the investment team, more ESG measurement upskilling of the client-facing teams, and less influence on ESG messaging from the marketing department.

The second issue will become more visible as corporate issuers will increasingly look to tap the now vast ESG AUM – in excess of Euro 1.1 trillion as of end 2020 in the EU alone, according to Morningstar – in order to satisfy the demands on corporations to fulfil their role in promoting ‘stakeholder capitalism.’ Green bonds, social bonds and, in my view, ‘stakeholder equity’ will soon become a significant source of financing activity – and allow those fund managers who truly mean what they say to put their ESG money to work in a focused and aligned manner.

Finally, I believe the investment industry needs to prepare for a conversation with clients that will soon upend their existing framework. In line with my prediction on capital market issuance trends above, fund managers will need to change their pitch about what makes them reliable and competent stewards of other people’s money. Instead of focusing on target returns, whether relative to a benchmark or absolute, and the concurrent expected volatility, investment firms will soon need to start talking first about the focused area of ESG impact of their investment programme – and only after that determine what the likely return outcome might be.  

ESG has come a long way very quickly, with profound implications for asset owners – institutional or retail – and how they interact with the agents that steer their savings – fund managers.  Current headlines and controversies will likely fade and soon the conversation will become: who is actually competent to meet investors’ future needs for impact investments? Investment firms unprepared for this type of discussion will struggle to be credible – and more than just headline risk, it will probably be an existential risk that becomes a concern as clients vote with their feet and move decidedly towards impact investing.  

Olivier Lebleu is Head of ESG, Edelman Smithfield.