Let’s start off by defining ESG (although there’s a good chance you won’t have got past the title if you didn’t know already!). ESG is the acronym for Environmental, Social and Governance.
It is shorthand for a filtering process, applied during investment decision making, to establish a company’s ethical, social and governance credentials. Behind it is an argument that those companies who have strong ESG credentials should have better long term performance: a company that spends its time and money in an environmentally sustainable way, that cares about its staff and their welfare, that is well run and managed will eventually profit over one that doesn’t. There is a body of evidence that supports the argument.
So, the ESG argument sounds like common sense, feels good and makes money.
Yet, in the sense that it has not been widely adopted, it doesn’t work in pension investment. Why not?
There are three reasons all built around one core problem.
The core problem is the evidence supports the argument that ESG filtering leads to better returns over the longer term i.e. it requires a buy and hold mentality. The evidence does not support short term out performance and may, in fact, hint at short term under performance.
The reasons are, firstly, most trustees, investment consultants and investment managers, although having a long term investment horizon, have short term vision. Every report produced for a board of trustees starts with three month performance! It’s hard to tell who fuels this short termism (is it the trustee who can’t hold her nerve, or the consultant and manager who feel they need to justify themselves quickly) but it is a fact.
Secondly, there remains a sense that ESG is slightly new age hippy and, as a consequence, doesn’t sit comfortably in the residual gung ho, macho, “lunch is for wimps” culture of the city. The “big guns” claims they make money by making tough and brave calls not by buying and holding.
Thirdly there are parties in the investment chain who make their living out of trading. A buy and hold strategy makes them less money. It is a perverse incentive that conspires against ESG.
Finally, and particularly in relation to DC investment, buy and hold is not consistent (or is more difficulty to manage) in a world where daily dealing is used – because of the need for liquidity - although this becomes less of an issue as we move toward scale. In a sense, this is also a perverse barrier, as daily dealing is only a perceived need, it is not a legal requirement.
ESG is a source of good: it produces better returns over the long term (consistent with the need of pension investment), it is better for the world, environmentally and socially and it is more efficient (because it doesn’t incur all of the costs of frequent trading). It’s time we looked at the barriers and tried to pull them down.
My thanks to Nico Aspinal of Towers Watson and Catherine Doyle of Newton who, in conversation, helped flush these issues out.