Why meaningful ESG investment results require risk management and transparency

ESG investing is at a crossroads as regulators are demanding more transparency just as investors face inflation's rising threat to portfolio performance. One of the key reasons that ESG investing faces such scrutiny from regulators is the historical tendency of some asset managers to repackage existing strategies by adding a sprinkling of "good" companies to create a "new-ish" product that's been labeled ESG-friendly - or worse, some firms don't bother to make any changes at all, call it an ESG strategy anyway, and invite regulatory investigation. I think that, publicly at least, everyone would agree ESG investing should be much more than that. To be effective for ESG-aware clients, ESG investing will need to make a fundamental change to the way portfolios are designed to include comprehensive risk control with targeted ESG directives and complete transparency.

By definition, ESG investing introduces risk into portfolios as it deviates from the original investment mandate, and therefore, from the originally selected benchmark. But risk is not always a bad thing. Let's take a look at the weight of the Energy sector (a "bad" ESG investment by anyone's definition) within three major equity universes going back to 2008, when the weight of the sector spiked. Since that time, energy's representation in each of the indexes has fallen sharply. Coincidently, ESG assets have grown rapidly during this period, rising well over 1000% between 2015 and today. And as assets rose, ESG exposure became virtually "free," as not owning the worst ESG names proved to be a winning result as those constituents fell in index weighting.