ESG information is a powerful analytical investment tool. It screens out bad actors, identifies unforeseen risks, and finds hidden opportunities. When genuinely implemented ESG strategies of all kinds address climate change, social inequities and promote sustainable values. A true nirvana increases returns while advancing global causes. Unfortunately, sometimes the best of intentions creates misleading or disregarded ESG policies. Below are some ways to get red carded on your ESG policy.

We invest in accordance with our investors’ “values”.

When was the last time a fund manager asked about your values? Many wealth managers ask clients to complete a values questionnaire but rarely if ever is this done by fund managers. Fund managers who’s ESG policy states their investments align with their investors’ values are selling a concept more than defining an ESG strategy. There are three main problems with values first investing: 1) What are the values of the underlying beneficial owners?, 2) How are competing values addressed (no guns vs 2nd amendment supporters)? and 3) The Department of Labor (DOL) regulations that govern ERISA investments.

Expanding on point 3 above, fund managers who are managing “plan assets” under ERISA must also keep in mind FAB 2018-1 of the DOL, which stresses in the context of ESG investing that fiduciaries must always put first the economic interests of the plan in providing retirement benefits. A fiduciary’s evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment (1). Profits before values when it comes to ERISA.

Investment managers can represent their principles and let them guide their investment strategy, which may also align with the broader objectives of society, but it’s probably a stretch or illegal to say investor values come first. Especially when they don’t even know those values.

Investment teams are two steps removed from the ESG strategy.

There is no investment process without the investment team. The same can be said about ESG. You cannot have a meaningful ESG strategy without the direct participation of the investment team. Direct participation is not having ESG information and engagement tangentially involved but having ESG embedded in the process. In fact, if the investment team does not buy into the value story of ESG information then ESG is simply ignored and only serves as window dressing.

What works is when ESG is an integral part of the investment process, has the full support of the CIO, and is reinforced with training. One way to get immediate buy in from the investment team is to link ESG to compensation. Nothing gets an analysts attention better than money.

When an investment manager doesn’t have its own ESG initiative.

Socially responsible companies are better companies, period. They practice environmental stewardship, respect their employees, and understand the benefits of diversity. These firms are simply better citizens. So, when a firm’s management doesn’t recognize the value of ESG in running their own company then how can they truly believe in the value of ESG within their investment process. If an investment manager truly believes in ESG and applies it to the investment process, then why wouldn’t they do the same for their own company? 

The investment manager should consider ways they can reduce their own carbon foot print, enhance employee engagement and diversity and get involved in industry and community events that promote sustainability and ESG principles. Actions of the owners dictate its culture. 

When investment team receives no training.

Investing using an ESG strategy or methodology requires training and reinforcement. ESG integration being the most common form of ESG investing requires investment teams to understand how to identify sources of risk and opportunity using material ESG information. Investment professionals often lack experience applying these principles. Training is one way to highlight the advantages of this strategy as well as reinforce its application. Training also helps the investment team better grasp the value and usefulness of ESG, and ultimately help connect the ESG strategy to the investment process, bridging the gap between ESG policy and implementation.

When there’s no independent review or assessment.

Independent review does not have to be assurance reporting conducted by a CPA firm. In fact less than 10% of US ESG reporting are examined by CPA firms. Independent review simply means someone internally or externally reviews adherence to the ESG policy and procedures in place. This review can be done as part of the compliance function or by an outside ESG specialist. The important point is someone independent from the process should confirm that what is stated is actually being executed.

Furthermore, the SEC Office of Compliance Inspections and Examinations has listed reviewing ESG as an examinations priority for 2020 so it’s also in the fund’s best interest to make sure ESG statements to investors are supportable by facts (1). An ESG SEC violation is a big investor red flag and is akin to getting caught cheating on an ethics exam.

Conclusion

There are many indicators of a faulty ESG policy or program. Most are inadvertently resulting the fact most manager’s are unfamiliar with this type of investing. Often, much of what managers know about ESG is learned from the media or casual conversation. So my advice to managers stepping into the world of ESG for the first time is go slow, start with the basics and never overstate your program. If a manager follows this advice and avoids getting a red card, they can start to realize the benefits of sound responsible investing strategy.

1Special thanks to Seth Lebowitz and Ron Geffner of Sadis & Goldberg LLP for their input and expertise on the ERISA and SEC content in this article.

For more information on this topic or impact investing contact ESGA at joe.holman@esgadmin.com.