ESG Funds: Institutional vs Non-Institutional

It is no secret that environmental, social, and governance (ESG) investing has been on the rise in recent years as investors and investment clients have shifted their mindsets toward societal concerns, while pursuing strong financial portfolio returns. The ESG acronym, first coined in the Freshfields United Nations Environment Programme Initiative in 2005, formed what could be considered the beginning of the sustainable investment movement.¹ The term was originally designed to be a useful metric in aiding investment managers with company selection. It was meant to be a screen that could help the investment community understand a company’s current health, and potential to earn future cash flows when measured with these factors. It was also a way to promote change and foster more sustainable growth. For example, when looking at a legacy energy producer per se, valuing the company without an ESG tilt, an investor may miss key factors that could dampen the future profitability of a company, such as a potential rise in carbon taxation, or the elimination of a key business operation with changing legislation. This novel ideology, which incorporates a good deal of investor activism, was a new way for asset managers to raise funds, and for investors to align their investment goals with their societal interests.

Looking at the below chart, global investor demand for professionally managed ESG funds has been matched with an equally large amount of supply. By 2024, at their current growth rate, ESG-mandated assets, which can be defined as assets where ESG subjects are key to investment-making decisions or shareholder resolutions, are on track to represent nearly half of all professionally managed assets globally.²

ESG mandated assets are projected to make up half of all professionally managed assets globally by 2024

Global assets under professional management ($T)

Source: Deloitte Insights

Now that we’ve discussed the size of the industry, you may ask how we got there, and what are some of the potential implications for the future. While ESG as an asset class is still relatively nascent in the world of investing, there are two distinct eras associated with this investment theme. The first, the old era of ESG, or the loosely era is where ESG funds saw their initial inflow boom. Vague guidelines as to what ESG actually meant, and how funds were allowed to market it, caused the asset class to boom.

As depicted by a recent Deloitte Insights study, ESG assets compounded at approximately 13.4% per annum since 2014, and are expected to reach upwards of $55T.²

As a result of this explosive growth, one of the most important hot-button topics that entered the regulatory microscope is how these fund managers actually assess and report environmental, social, and governance data they market.

When investors started to look under the hood, an unfortunate finding of this unchecked growth was the vast amount of greenwashing that had ensued at the fund manager level.

Greenwashing, as defined by the Corporate Finance Institute is “when the management team within an organization makes false, unsubstantiated, or outright misleading statements or claims about the sustainability of a product or a service, or even about business operations more broadly.”³

Unbeknownst to investors who thought they were investing in funds that deployed capital to ESG-compliant companies, were portfolios and underlying investment theses that lacked substance. These firms, with limited ESG track records, and what we would refer to as non-institutional in nature, took advantage of the lack of regulation and accumulated vast fee-generating assets, though non-ESG compliant. Environment, Social, and Governance investing has come with confusion and disagreement about the definitions of terms like ESG, sustainable investing, and impact investing.

According to Deloitte, the number of investment managers that reported at least one ESG fund in their portfolios grew by nearly 300 percent since 2016. And as ClearBridge Investments’ Mary Jane McQuillen puts it, “because it bloomed very quickly, there are lots of pockets including managers and asset owners who may have a very narrow view and may not be practicing ESG investing to the same extent that many of the original practitioners had intended.”⁴

Source: SG Analytics

As evidenced by the rising fund prospectuses, for good or for bad, ESG as an asset class has moved to be mainstream, and we believe that we’ve now entered a transient period, propelled by legislation, where professionally managed assets with a genuine ESG mandate can flourish.

Unsurprisingly, the dramatic growth of ESG funds attracted increased attention from the SEC and other regulating bodies. Last year, with the growing number of greenwashing claims, the SEC’s Division of Enforcement formed a Climate and ESG Task Force to analyze claims by fund managers and further develop fiduciary responsibility. Mr. Gensler, chairman of the SEC, asserted that the process for selecting an ESG fund should be as straightforward as purchasing a carton of milk labeled fat-free and suggested that he would advise the SEC to pursue new disclosure rules for ESG-focused funds⁵

The resulting outcome, the New Era of ESG, or the heightened-regulated era as we will soon know it, is where the environment may actually achieve the mandate’s original intent that sparked investor interest in ESG investing in the first place. Regulatory bodies and government agencies have mandated public companies to adopt ESG-related reporting through an ESG disclosure. For many public-traded companies, management teams must report the firm’s ESG practices or otherwise face backlash from the market. For investment managers that are marketing ESG funds, expectations are that ESG characteristics and risks will be required to be quantified, measured, and play a meaningful role in the fund’s investment-making process.

Breaking down the ESG disclosure into 3 parts is:

1. E - Environmental Sustainability: relates to the impact a company’s operations have on the environment, most commonly measured by carbon emissions or carbon footprints.
2. S - Social Impact: describes a company’s initiatives to give back to society through social programs aimed at employees, customers, and broader communities, such as sponsoring charities.
3. G – Corporate Governance: looks at a company’s internal practices in managing an equitable organization, emphasizing Diversity, Equity & Inclusion (DEI) metrics, and transparency across executive compensation.

Out of the vast ESG fund universe, approximately $4.37 trillion in assets were held in private market funds committed to ESG investing by the third quarter of 2021. Broken down a bit further, the greatest share of these assets is are held in private equity and venture capital funds, making up approximately $2.26 trillion under management.⁶

Given the rapid scrutiny of the ESG funds universe, increasingly, advisors are looking for measurable due diligence and reporting, beyond just marketing an ESG fund label. Advisors want to know how, and how consistently an investment manager sources and uses ESG data in their investment-making decisions.

While it may be tough for smaller emerging managers to conduct this type of due diligence, institutional managers with deep teams and financial resources may have a competitive advantage in meeting diligence requirements such as rigorous screening, generating ratings, measuring and producing investment impact reports, and ongoing operational support. The below chart outlines some of the key attributes of a sustainable investing leader, and one that is aligned with the practices of an institutional asset manager.

Source: Casey Quirk analysis

Source: Deloitte

As ESG momentum continues to build, and the space evolves further, investment managers will likely feel increasing tension between their clients’ desires, a number of evolving regulations, and how they feel is the right way to take part in this new paradigm – all while keeping to their fiduciary responsibility and maximizing portfolio returns. As the jury is still out refining the regulatory framework, the final outcomes, though anticipated, are still under discussion. While larger institutional funds do have resources that may give them an edge, like the rest of the investment management space, it does not make them immune from a regulatory finding that they did not follow ESG rules, principles, or that they engaged in greenwashing. Ultimately, understanding the investment objectives as well as the risks and limitations of any ESG investment is a critical aspect for any investor (regardless of the size or reputation of the management group behind a given project).

Using an investment platform often has an added layer of due diligence conducted on the platform level. Only funds that have passed the platform’s due diligence requirements are presented to the advisory cohort. Often, the platform’s due diligence requires many conversations with an asset manager and the opportunity to ask more pointed questions that individual investors may not be privy to.

Sources:

1. ESG Analytics, October 2005. "Where Did the Term ESG Come From?"
2. Deloitte, April 2022. "ESG Investing"
3. Corporate Finance Institute, July 2022. "Greenwashing"
4. E&E News, July 2022. "ESG Two Decades Later"
5. Harvard Law, April 2022. "Litigation Risk Posed By Greenwashing"
6. Barron's, July 2022. "Private Funds Focused on ESG are Facing Transparency Push"