ESG Investing: The Peak Perspective

ESG Investing: The Peak Perspective

We believe the rising popularity of ESG (Environment, Social, Governance) investing strategies creates additional opportunities to have honest conversations with our clients about their financial goals and the strategies that are available to achieve those goals. While it is indeed a worthy endeavor to align an investment strategy with one’s values, there are reasons to be skeptical about some of the buzz currently tied to ESG investment products.

Our job is to help you parse the signal from the noise as a flood of ESG investment products and marketing campaigns overtake the financial services industry. While there are reasons to be skeptical of surface level claims about ESG investing, our strategy is to seek out active fund managers with a differentiated approach that have practiced values-based investing for decades. We would be excited to discuss these strategies with you.

What is ESG?

There is no widely accepted definition for “ESG investing”. We can define the acronym, but that’s where the consensus ends. Historically speaking, ESG is an outgrowth of “socially responsible investing” (SRI), whereby particular stocks – such as tobacco companies or gun manufactures – would be excluded from a portfolio.

The promise of ESG investing today is that it goes beyond negative screens and into the realm of “impact investing.” The potential to make an impact is implicit in the idea that an investor’s capital can be allocated or rewarded to companies that “score” well on ESG criteria; simultaneously, capital is withheld from companies that score poorly. From this it follows that businesses will be incentivized to improve their practices tied to environmental, social, and governance issues in order to increase their access to capital markets and lower the cost of capital.

The challenge – or perhaps impossible task – is that value judgments are subjective, and thus the scoring models used to rate ESG criteria are equally subjective and qualitative. This makes it challenging for investors to know (both in advance and after the fact) whether capital allocation decisions are making the impact that the investor set out to achieve.

If an oil and gas company is spending billions of dollars on wind energy development, should we assign them a high or low ESG rating? The company’s current profile of greenhouse gas emissions is a knock against them, but their investment in the transition to a cleaner energy future may be vital. From this simple example, we can see how difficult it is to not only select and identify ESG criteria, but to assign an objective, quantitative score to criteria once they have been identified.

ESG as a Framework for Risk

Can an investor “do well” by also “doing good?” In the past, SRI investors acknowledged that aligning one’s values and investments could come at a cost to portfolio returns. Today, we hear the opposite. ESG strategists argue that you can both beat the market and make the world a better place with an ESG investment strategy. On the surface, the idea makes intuitive sense: by controlling for the risks in a business’ environmental, social, and governance practices, investors can achieve outsized returns by selecting businesses that effectively mitigate the costs of climate change, retain valuable employees with a healthy company culture, improve shareholder protections with sound governance practices, etc.

The problem with this argument is that it falls apart in the context of the most important relationship in finance: risk versus return. While risk comes in all shapes and sizes, overpaying for an asset is one of the most significant risks in investing. An ESG-friendly label does not eliminate this risk. No matter how successful and wonderful an investment and its ESG credentials may be, the risk remains that investors overpay for the asset and ultimately realize lower-than-expected returns. With the current excitement and marketing behind so-called ESG investment products, massive fund flows rushing into these strategies can drive prices higher and increase the probability that investors overpay for the underlying assets.

That is not to say that it isn’t important to control for risks in a company’s business model when purchasing a stock or fund. Rather, the practice of identifying the risks associated with a business, and simultaneously adjusting the price you are willing to pay to own a piece of that business, is as old as investing itself. Labeling risk factors under the umbrella of “ESG” is simply new vernacular for a long-standing practice in security selection.

Strong Businesses Make an Impact

When we look at our model portfolio, we are not surprised to find that most of our investment ideas score well on ESG criteria.[1] The simple fact is that strong businesses have the optionality to make investments and improve outcomes for multiple stakeholders. There is no way to know or measure which direction the causality runs: Are socially conscious businesses more successful financially and thus better able to invest in the business and the wider community? Or are financially successful businesses better able to invest in practices that improve outcomes tied to environmental, social, and governance issues? Either way, we believe in buying and owning the best and strongest businesses in the world.

An Active Approach is Needed

Despite our skepticism associated with some of the claims around ESG investing, we believe a truly active and differentiated investment strategy can make a positive impact on the world. Active fund managers can build internal risk assessment models tied to environmental, social, and governance issues. With in-house research teams, these active managers are not dependent on opaque rating methodologies from external providers. This allows the fund manager to articulate a specific values-based approach and bring it to life through active security selection. Active managers can also look to the future and analyze how businesses are improving their practices tied to ESG issues, rather than relying solely on backward-looking data to make values-based judgements.

Perhaps most importantly, active managers can aggregate capital, build meaningful ownership stakes in companies, and use their influence as an owner to work with boards and management teams to improve business practices. At Peak, we have designed ESG portfolios for interested clients by selecting specific asset managers and strategies that take this active approach.

Due to the rapid proliferation of fund managers attaching an ESG “overlay” to their strategies, our job as fiduciaries is to wade through the universe of available ESG strategies and identify those active managers that walk the walk, not just talk the talk. We would welcome the opportunity to discuss our approach with you and share more information on the ESG models we have developed at Peak.

 

For more information on the latest trends in ESG investing, we thought this was an excellent summary video from the Wall Street Journal. Click here to view the video.

 

*The Model Portfolio is not a real cash portfolio. It represents the core direction of our portfolio management strategies. Individual client portfolios are managed in accordance with the clients’ specific investment objectives and constraints. Historical results are available upon request.

Peak Asset Management, LLC is an SEC registered investment adviser. This is not an offer to buy or sell securities. Past performance is not indicative of current or future performance and is not a guarantee. The information set forth herein was obtained from sources which we believe to be reliable, but we do not guarantee its accuracy.

[1] Using the MSCI ESG Ratings