Considering the social impact of investments with risk and return might not always be the best idea.
This column was first published in Business Day.
We are increasingly in love with the idea that investments can do good and not just deliver a financial return. Pressure has been growing worldwide for investment managers to consider the social impact of investments alongside risk and return. In SA, regulation 28 of the Pension Funds Act requires pension fund managers to think about the trifecta of environmental, social and governance (ESG) issues when making investment decisions. A guidance note in 2019 from the Financial Sector Conduct Authority said funds should put ESG criteria into their investment policy statements and make these available to members.
Recent research by my firm Intellidex found that almost all pension fund principal officers are expecting sustainable investing to become more important over the next five years, and some even think it is more important than generating returns.
This direction of travel appears to be positive, but I’m sceptical about the conceptual starting point. If we can use investments to make the world a better place and not only deliver a financial return, that seems an obviously good thing. Many argue that sustainable investing can deliver better financial returns anyway. This argument is convenient in that it helps remove tension between those who benefit from the financial returns of an investment and the social returns. Seldom are these the same people.
But I doubt that we can magically get both financial returns and ESG. It seems on purely logical grounds unlikely that ESG investments will match or outperform non-ESG investments for several reasons. One is that as the popularity of ESG investing grows, demand increases for compliant investments, increasing their price and therefore reducing potential returns. Another is that an ESG investing strategy is about constraints — avoiding investments that don’t fit set criteria.
A fund that is constrained has a narrower investment option set by definition. An unconstrained fund can mimic the strategy of the constrained one, but always have the freedom to deviate when tactical opportunities come its way. It seems illogical to say that the constrained fund can outperform the unconstrained one.
The argument against this seems to be that investments that meet ESG standards overcome companies’ natural tendencies to focus on short-term profits that cause longer-term problems. There may be something to this. Bonuses and other performance incentives must be specified in easily measurable terms and fit the normal remuneration cycle. Reward systems are much easier to use for short-term financial targets than objectives of 10 to 20 years with hard-to-measure outcomes like better relations with the local community.
Companies take higher risks and ignore long-term costs, resulting in rewards to managers but pain to shareholders when risks don’t pay off and long-term costs come to bite. So, by pushing a set of ESG objectives onto company managements, one overcomes the problems of short-term incentives leading to companies that create greater long-term value for shareholders.
This seems to be the argument that influential fund managers such as BlackRock advance in saying its “investment conviction is that sustainability-integrated portfolios can provide better risk-adjusted returns to investors”.
I can buy that ESG forces a greater alignment between managers and shareholders, but that is not meant to be the point of ESG. If ESG is just a management-discipline tool then we should call it that. But ESG is meant to be about stakeholder capitalism, ensuring that all interests of those affected by companies are considered. And it cannot be that shareholders are always going to be aligned with other stakeholders, unless there is some radical redefinition of what shareholders’ interests actually are.
If shareholders genuinely desire positive social outcomes, and not just good risk-adjusted returns, then there may well be the possibility of alignment. Shareholders’ return set would now consist of both financial and social returns. But if they value the social returns, they should be willing to give up some financial return in an effort to maximise both. We would then see the market reflecting these views, with prices rising for ESG investments, reducing yield on such funds. Again, it would be the case that financial returns were being sacrificed to achieve positive ESG outcomes.
Some impact investments make this explicitly clear. You can right now go and put your money into Kiva microloans, a nonprofit crowdfunding mechanism that provides loans to individual borrowers in emerging markets. You would get no interest on your loan, but the idea is to get your capital back and to help an identified individual (for example, you can chose a vulnerable refugee) whose progress you can track. Their success is the social return you get for sacrificing the financial return of interest you could have earned on your money.
When it comes to companies applying ESG criteria, I think it is important that companies are clear about where they are willing to give up financial returns if it has a big social impact. Banks, for instance, should be clear about reallocating capital to lending that might reduce yield but increase impact. That should be measured and communicated to stakeholders.
Institutional investors need to think through their mandates and alignment with their clients’ views on social impact. It is no longer acceptable to declare that fiduciary responsibility requires that risk and return be all that matters. We need to take social return seriously, gauging our clients desire for it, and then using it in decision making. We need to be honest that ESG strategies are not only about maximising financial return.
Theobald is chair at Intellidex.