ESG “Elitism” and Bridging the Public-Private Divide
Note: This article has fewer sources than usual because it is in part sourcing my personal experiences working in the investment world at Goldman Sachs and other places.
Fast Scrolling Table of Contents:
- Title
- The Divide in the ESG Market
- Why Public ESG Funds Are Falling Behind
- What Should Public ESG Funds Do to Keep Up?
- Sources
In the world of investing, ESG (Environmental, Social, Governance) has emerged as one of the “hottest trends”. ESG is investing for more than just returns; it incorporates “socially responsible” criteria that aim to solve externalities and promote public “good”, such as avoiding oil firms, reducing a portfolio’s GHG emissions, investing in firms that treat employees and customers well, and investing in companies with strong corporate governance. Some ESG investing does aim for outperformance, but this is neither a requirement nor the current standard. In tech investing, ESG is garnering significant attention because it is propelling areas like cleantech, sustainable tech, ESG data, etc.
The Divide in the ESG Market
Sizing this market is difficult because of the data being spread out and the fact that there is not consensus on what is “ESG”. We can agree that an investor screening for coal is ESG and an investor only looking for high return opportunities is not, but grey areas exist in the middle. A lot of the ESG market statistics are highly inflated because they include this contentious middle ground. For example, funds that “consider ESG” but are not focused on sustainability (like the JP Morgan US Equity Fund) are counted as the figure below shows [1]; technically they may consider ESG factors, but ESG is not the intent of neither the fund’s investors nor the buyers. This is like buying the $845k Porsche 918 Spyder [2] for its excellent fuel economy (67mpg) [Spoiler: you never cared about the fuel economy; you just wanted a Porsche supercar].
So, while claims like ESG soon being 33% of global AUM [3] are suspect given these grey areas, we do have data on funds (public open-end mutual funds / ETFs and private funds) committed to ESG. When we run this data (note that the data presented below is an estimate given that many different sources had to be amalgamated to create the analysis), we see a stark divide between the general investing market and the ESG market. Globally, public funds (open-end mutual funds and ETFs excluding money market) were pegged at an AUM (assets-under-management) of $60.0 trillion in 2021 [4], while private capital (private equity, infrastructure, etc.) AUM was estimated to be $8.5 trillion in 2021 [5]; this implies a public-private ratio of 7.0x. When we filter this down to the dedicated ESG space (trimming away the problematic “grey” areas), public AUM is estimated to be $1.3 trillion [6], while private AUM is estimated to be $0.6 trillion [7]. In ESG, the public-private ratio is 2.2x, significantly below that of the general market.
What is causing public ESG funds to be relatively “behind” vs. the general market? Why have private ESG funds (impact space) been much more successful, garnering 7% of private AUM vs. public ESG garnering just 2% of public AUM? Public investors have overwhelmed the media with their commitment to ESG and their expectations of significant market growth, but why have the dollars not followed the hype? The answer comes down to a multitude of factors, from ESG “elitism” to behavioral finance to a lack of consensus on ESG. This is particularly important because public funds are essential to finance (though on the secondary market) publicly-listed firms, and without public ESG funds, firms that focus on cleantech, social technology, sustainability, good corporate behavior, etc. have less of a chance to reach the forefront.
Why Public ESG Funds Are Falling Behind
1. “Elitism” at the Institutional Level — Institutional investors often comprise the LPs of private funds, but are a bit less common holders of open-end ETFs and mutual funds (largely due to fees). However, the institutional sales process for public ESG funds is more difficult than public funds overall due to very specific institutional preferences. It’s not that institutions are not committed to ESG; it’s that they are too committed. They care so much about ESG that, combined with the lack of agreement on the “best ESG metrics”, institutions have specific, tailored, and differentiated preferences on what they want to invest in. For example, one institution might want no coal in their portfolio, another might only want metallurgical coal, and yet another might not want to exclude coal altogether. Given their commitment to ESG, these institutions care a lot about their own preferences and are unlikely to compromise even on seemingly minute differences in investment philosophies. Often times the institutions who are significant holders of public funds had those made for them in exchange for their investment, but this fund is unlikely to attract other major institutions who remain very “elitist” about their own views. Thus, institutions often go with CMAs (custom managed accounts — custom portfolios) for public ESG where they can get lower fees and customize their ESG dollars.
2. More Intuitional Impact in Private ESG — The two sides of ESG, public and private, are less so two sides of a coin and more so cousins. They both care about sustainability but go about creating change in very different ways. Public ESG investments aim to affect change by pushing up the stock prices of firms that engage in sustainable practices or good corporate behavior, but less often is about control or reshaping firms; it is more of a passive (but not completely given voting power) process. Private ESG investments can take smaller positions like their public counterparts, but much more often are about investing in the primary financings of ESG firms and driving change through targeted value creation. For example, funding a solar energy firm to create better panels and change the market. Intuitionally, having impact is more straightforward to understand in private ESG, so it has attracted a bigger share of the pie.
3. Perceived Return-Impact Tradeoff in Retail — Retail investors, who are a large investor base in public funds, have a pervading belief that ESG does not improve returns and that there is some sort of tradeoff where high ESG/impact leads to lower performance. For example, a survey of retail investors [8] found that only 13% believed ESG would add to returns compared to 40% of institutional investors in another survey [9]. Adding on to this, a PWC survey found that only 34% of investors said they were “willing to accept a lower rate of return in exchange for societal or environmental benefit” [10]. Though there is industry and academic evidence showing ESG being correlated with outperformance [11], these perceptions (especially in retail) have kept funds from flowing into public ESG funds.
4. Investor Loss Aversion — Loss aversion is a behavioral finance phenomenon where a person is more sensitive to a loss than an equivalent gain. For example, you would rather avoid losing $2 than gaining $2 on your investment. While ESG will often not lead to an absolute loss, Prospect Theory [12] implies that once investors benchmark themselves to an expectation (the market portfolio), any underperformance is perceived as a loss. This phenomenon is fairly widespread and results in investors not taking appropriate risks or trying novel investment ideas. Especially in public funds where investors can sell easily and review performance daily, loss aversion is common. A Schwab and Cerulli survey [13] found that loss aversion was most frequent in Millennials but still high in other generations. This is problematic because the generation that most cares about ESG (and is rapidly accumulating wealth) [14] might be too loss averse to significantly adopt it in public funds. This can also explain why, as the PWC survey [10] showed, 79% of investors agreed ESG is important but only 49% were willing to divest from “bad” firms.
5. Financial Advisor Incentives — There’s a saying in wealth management that “if you outperform you get a pat on the back and if you underperform you get a kick in the a**”. For the fees (often 1%) that individuals/families pay wealth managers, there is almost an implicit expectation that the wealth manager will offer something over the market. If a manager outperforms, it’s good (but somewhat expected) news and is met with praise and self-affirmation. If an advisor underperforms, investors become very sensitive because they are underperforming on their investments on top of the hefty management fee. Building off the last risk aversion point, advisors face an asymmetric risk reward profile that give them caution to adopt ESG unless their clients really want it because they do not want to justify any future ESG vs market underperformance. And if clients really care about ESG, they often have tailored (see ESG “elitism” point) preferences that need specific mandates vs. funds.
6. Damned if you do, Damned if you don’t — An oft-used solution in investing to take on exposure with loss-averse investors is to optimize for low tracking error; this means that the portfolio is mathematically optimized so it can achieve a certain exposure (to tech, ESG, carbon footprint, etc.) but the actual performance will be very similar to the market. With ESG, this is a double-edged sword because with low tracking error, investors can question if their ESG portfolio is even having any impact since it is performing just like the market. And on the flip side, too much tracking error leads to impact but loss aversion if the portfolio underperforms.
7. No Standard in ESG — Despite the efforts of Sustainalytics, MSCI, ISS, and the like, there are no unified standards in ESG. 46% of retail investors [8] and 75% of institutions [10] cited a need for more information or central standards. This inordinately affects the public space because the investments are often about constructing a portfolio based on metrics rather than control investments in ESG innovators. Furthermore, lack of consensus has fragmented the market and prevented public funds from achieving scale. The scoring mechanisms that do exist often have to go to battle with investor heuristics. Exxon Mobil is ranked #45 out of 928 firms by JUST Capital [15] in how it treats communities, but some investors looking at this would see Exxon as such a big polluter that they would reject JUST’s ESG rankings.
What Should Public ESG Funds Do to Keep Up?
The above presents a litany of problems holding public ESG back. Should public asset managers deprioritize getting ESG into every investor’s hands? This is not a death knell for public ESG; asset managers need to take more targeted approaches if they want to replicate private fund success in the ESG space. This means focusing on a smaller market, segmenting demand, and reshaping their strategies to meet investor concerns on tradeoff and impact.
1. Focus on the “G” (Governance) — While the “E” (Environment) and “S” (Social) of ESG are often in sharp focus, the “G” (Governance) is underdeveloped for public funds. Governance is where private ESG funds shine since they often take significant stakes in firms and can effect change through being active investors. While public ESG funds do have some governance criteria, more can be done. First, like how “E” and “S” use alternative data, public funds need to research novel data sources that are predictive of good governance. Most importantly, funds need to put their votes where their mouths are; research [16] has shown that ESG funds don’t always vote their shares to support sustainable measures. Like their private cousins, public ESG funds need to be active investors when it comes to voting and push the ESG agenda. This gives more of an impression of impact and can attract more investors.
2. Don’t Undersell the Impact — Effecting change with public ESG dollars is not as straightforward as doing so with private ESG dollars, but is still possible and should be emphasized to investors. Public ESG funds need to market more their impact in terms of voting record, pushing management (as an industry) to do better, carbon footprint reduced, etc. Marketing and pushing these metrics to investors keeps them top-of-mind and moves the conversation away from performance and loss aversion and towards why investors buy ESG funds: to drive change and have impact. For example, a fund manager can make a tool that can look at an investor’s portfolio, suggest comparable ESG options, and detail how their impact on the environment, social issues, etc. can be much improved without fundamentally shifting the portfolio.
3. 20% of 40% is more than 2% of 100% — Driven by asset managers wanting to capture the whole market, public ESG has had to be diluted down to where it has not appealed as much to its core buyers. Having funds with slight tilts or optimizations or broadly aggregable criteria makes investors who have higher convictions about ESG not care as much and the broader market might be too loss averse and not educated enough to adopt significantly. Public ESG funds should aim to narrow their target market and create more tailored products that can lead to greater market share in these subsets.
4. Marry It with Thematic and Tech — We have to talk about this since this is a tech blog and technology investing is comprising an ever increasing portion of investors’ collective mindshare. A solution to investor concerns about the “impact” of public ESG is to recast it as a way to access unique return opportunities. Instead of just overall ESG investing, asset managers should organize ESG funds around themes and technology, like cleantech, solar energy, less lawsuits, innovation from governance, etc. In the end-investor’s mind, this approach allays fears of a return tradeoff and shows investors directly what kinds of industry or companies they are contributing to.
Sources
