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Mark Northway: Why ESG evangelists need to zoom out – #WorldEarthDay

This article features as part of IFA Magazine’s celebration of World Earth Day

Some ESG investors will only select like-minded managers that focus exclusively on ESG – but relying on subjectivity and emotion may be a mistake according to Mark Northway of Sparrows Capital, as he shares his thinking with IFA Magazine.  

Competition in the ESG sphere is heating up, but the race isn’t necessarily all about assets.

As the environmental, social and governance space has burgeoned – propelled by a nitroglycerine-like performance boost during the pandemic – financial advisers and consultants are understandably searching for the best options for their clients.

Assets under management paint a confusing picture as experienced ESG boutiques are rapidly eclipsed by larger rivals, whose gargantuan marketing budgets have helped them hoover up investors’ ethically focused cash.

So where to turn? Well, it seems that ESG specialisation is the defining characteristic that many believe sorts the wheat from the chaff.

The conviction in this is so strong in some quarters, that some fund selectors, advisers and consultants refuse to accept that an asset manager can run traditional investment products alongside ESG offerings, and there is a growing tendency to mark such firms down in the due diligence process.

Blinkered view

On face value, this might make sense. Why not choose someone whose focus is entirely on one thing, and who is passionate about this area?

The problem here is multi-faceted, but two aspects are particularly important.

Firstly, if a firm has always done one thing and one thing only, there’s an argument to suggest that they might not be able to see its pitfalls.

ESG is undoubtedly having its moment in the sun, but what does an ESG portfolio actually mean in terms of risk?

Intuitively, the application of filters and the introduction of active share relative to the market portfolio should negatively impact risk / reward characteristics.

A traditional ETF portfolio might comprise as many as 4 times the companies in it than an ESG / SRI equivalent, meaning investors are increasing their concentration risk, sector skew and geographic concentration.

Lack of objectivity

The other problem relates to the subjective nature of ESG investing.

Investors would love to believe that the long-term performance of investing in sustainable companies will be superior to that of the broader market. The belief is that because the strategy aims to ‘do good’, ethically speaking, it will also ‘do well’ financially.

This is attractive as a belief set but isn’t neatly supported by history. Indeed, it’s arguable that some sin stocks, notably tobacco, have traditionally produced outsized gains for investors – in tobacco’s case, in spite of litigation and rising public awareness about the harm combustible cigarettes cause.

It doesn’t unequivocally follow that just because capital moves to sustainable stocks that they will do well ad infinitum and applying an ESG filter to a portfolio is a decision based primarily on conscience and principle, both subjective criteria.

Subjectivity is the prerogative of the investor. Asset managers should surely respect the intentions and preferences of investors, but should objectively apply expertise, science, academic findings and financial objectivity while doing so.

A wide spectrum

As with most fields, the choice of manager depends on the circumstances and on the specific purpose and requirements of the portfolio.

Professor Elroy Dimson, chairman of the Centre for Endowment Asset Management at Cambridge Judge Business School, would argue that once you’re divested, you have no influence over a company whatsoever.

Impact investing sits very close to philanthropy on the ESG spectrum – where performance expectation is likely to be secondary to the primary goal of positive change. Here there tends to be direct involvement with target companies at a strategic level and is a clear need for specialist focus.

But for most investors impact will be separate from the core investment portfolio, and here the need is for selection and stewardship across a much larger universe of investable companies. This is where screening and weighting are key, and where traditional manager skills are the order of the day.

Investors need their managers to be specialised and focused not in belief sets, but in the management of robust, data-backed processes, and in the execution of client preferences in an unbiased and unemotional way.

Mark Northway is an Investment Manager at Sparrows Capital.

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