Focus on quick returns is not compatible with backing sustainability and energy transition.
In June 2004, at the invitation of the UN, a group of asset managers, banks and insurance firms launched a 60-page report called “Who Cares Wins”. In the introduction, a phrase was used for the first time that would change the face of investing.
“Analysts are asked to better incorporate environmental, social and governance (ESG) factors in their research where appropriate,” it said, marking the first mainstream mention of the term ESG.
In the ensuring 17 years, total assets in sustainable, or ESG, funds swelled to a record $2.7tn according to Morningstar — driven by a mix of rising awareness of the threat from climate change, as well as the outperformance of these funds.
But now, two decades on from the first use of the term ESG, the acronym is fast becoming a dirty word. Concerns have risen over “greenwashing” — the deliberate use of misleading environmental claims to lure well-intentioned potential investors. And, in the US, the term ESG has been politicised, with Republican politicians relentlessly criticising money managers such as BlackRock for being too “woke”.
This has resulted in the rapid flows of money into these funds being followed by equally rapid flows out of them — highlighting the systemic structural problem with sustainability investing: the mismatch between a fund’s performance over a one-, three- and five-year period, and the longer payback period needed for this type of investing.
“Short-termism has been a problem in financial services for a very long time and it is a particular challenge around sustainability,” acknowledges James Alexander, chief executive officer of the UK Sustainable Investment and Finance Association.
Part of the problem lies in the nature of asset management companies and their reporting structures. Most of the bigger asset management firms in the UK are listed, and therefore report quarterly results, which include the performance of these funds. This encourages asset managers and portfolio managers to think on a short-term basis, and risks prioritising quarterly returns over longer-term performance.
“We’ve got a long-term problem [climate change] but we still look at investment in a pretty short timeframe,” explains Alexander. “Much of this issue stems from the fact that a lot of these companies are listed.”
It is exacerbated by an industry focus on the one-year performance of investment funds, over and above three- or five-year returns. This leads to a “horrible behaviour finance effect”, whereby funds that outperformed in one year see a lot of investment in the next year, points out Rob Gardner, co-chief executive officer at investment company Rebalance Earth.
“Typically, a year or two later, often those funds end up being the worst performing — not because they’ve had a tonne of inflows, but because these things are cyclical and they are dependent on a particular theme,” he says.
This tendency to short-termism also affects the way funds invest. Across the fund management industry, the average holding period for shares is 3.6 years, according to data from Baillie Gifford — which is at odds with the long-term commitment of capital that is needed for structural sustainable change. “We are investing in companies who will navigate the transition well,” notes Catherine Flockhart, head of ESG at Baillie Gifford. “That is not going to happen overnight.”
As a result, there is a fundamental contradiction between the way funds are now invested and the way solutions to climate change and nature loss must be delivered: they require a significant amount of investment to be locked up over a long period.
“We’ve somehow ended up in a world where all decision making is now distilled to a time horizon, and the payback period just doesn’t make sense,” says Gardner.
However, the development of sustainability disclosure requirements in the UK — a set of Financial Conduct Authority regulations that aim to tackle greenwashing by improving the transparency of funds — may encourage investors to start thinking on a longer-term basis.
Under these requirements, which start coming into force from the end of May, sustainable funds will have to disclose information around time horizons and the progress they are making towards their targets, which introduces investors to the notion of holding periods.
“This will help investors think more strategically and introduces a new conversation,” says Hortense Bioy, global director of sustainability research at Morningstar.
For example, a new “sustainability improvers” label will be applied to funds investing in assets that may not be sustainable now, but are aiming to improve their sustainability over time.
But some believe there is more work to be done, for reasons beyond achieving strong returns. Gardner, for example, argues that investing in sustainable funds is not just a financial priority. He says that part of asset managers’ responsibility to clients is their fiduciary duty to ensure not only that fund holders have enough money, but also the kind of world that creates.
“If you’re retiring into a world which is full of pollution and dirty air and no nature, but you’ve made [the pension holder] £20,000 a year to live off, is that a good or a bad outcome?” he asks.
© The Financial Times Limited 2024.
All Rights Reserved. Not to be redistributed, copied or modified in anyway.
Money.it has hosting rights to certain limited Financial Times articles. This is not a live feed of Financial Times content.
