The EU Wants to be Your Green Investment Adviser
— April 15, 2021
By Paul Tice
Given the world’s interlocking financial markets and the global nature of the asset management industry, bureaucrats in Brussels may soon be dictating what U.S. investors can buy in their 401(k) accounts.
Since 2015, ESG analysis—the investment theory that corporate securities performance is driven by a host of morally-tinted, non-financial environmental, social and governance factors as opposed to objective, quantifiable financial metrics—has swept across Wall Street, spurred on by European pension funds and financial institutions as well as United Nations-sponsored advocacy groups such as the UN Principles for Responsible Investment.
But despite a lot of public lip service, ESG considerations are still not driving investment decisions by most asset managers, particularly in the U.S. In its 2020 Annual ESG Manager Survey, Russell Investments found that 71% of 400 respondents did not use any portfolio performance measures directly tied to ESG or climate risk criteria.
Clearly, a voluntary approach to ESG integration is not working. Global investor capital is still not being re-directed away from those politically-incorrect sectors and companies deemed “unsustainable,” especially when it comes to the “highest priority ESG issue” of climate change.
Cue the European regulators.
Under the new EU Sustainable Finance Disclosure Regulation (SFDR) framework being rolled out this year, European investment firms will need to start disclosing sustainability data for all of their managed funds, based on a new ESG reporting classification. For example, an SFDR Article 6 fund would largely ignore sustainability considerations, while an Article 8 fund would promote “environmental and social characteristics” and an Article 9 fund would be designed to have a “sustainable impact.”
Since an indifferent Article 6 label would likely lead to fund outflows and an Article 9 designation would set a high bar for actual achievement, it is safe to assume that most accounts will be categorized as Article 8 compliant under the new SFDR taxonomy.
Notably, Article 8 funds can only invest in companies demonstrating “good governance standards” which, in the absence of any definitional clarity from EU regulators, means that fund managers will now be forced to justify every investment that they hold. Such a portfolio line-item “comply or explain” standard is likely to push most managers to outsource the name approval process to so-called ESG third-party experts (such as the UN Global Compact) in order to simplify decision-making and limit manager liability.
The new EU SFDR rules will apply to investment firms based in Europe as well as any fund manager that actively markets funds into Europe. Effectively, this will give the regulations extra-regional reach and set the global ESG disclosure default.
Based on PwC estimates, Europe accounted for 27% of the industry’s $101.7 trillion in global assets under management as of year-end 2020, with European firms (many with U.S. operations) comprising 17 of the world’s top 50 investment managers.
While the Biden administration may eventually follow Europe’s ESG lead, the immediate effect of the EU’s green regulatory initiative will be to create onerous reporting requirements and additional costs for the U.S.-centered industry, while limiting portfolio flexibility and return potential.
The majority of present-day investors—especially in the U.S.—did not sign up for an environmental and social justice agenda when they allocated capital to an asset manager, making the ex post application of such criteria—even if mandated by an activist overseas regulator—a fiduciary breach.
Thus far, empirical studies have shown only a tenuous linkage between ESG factors and corporate securities performance, which is not surprising given the extensive and ever-changing list of subjective, morally-relative topics animating ESG activists. While climate change remains paramount, the target list hits most liberal hot buttons including diversity, union power, gender pay equality, executive compensation and corporate tax responsibility.
The main problem with an exclusionary sustainability-driven investment approach is that it ignores the efficiency of the financial markets and their ability to price almost any risk. As the old Wall Street axiom goes, “There are no bad stocks or bonds, only bad securities prices.”
At best, ESG is a broad catch-all for all negative corporate event risk; it has yet to be proven as a positive catalyst for investment performance over the long term.
In fact, a 2020 joint research study by the Georgia Institute of Technology and Northwestern University found that becoming a UNPRI signatory and implementing an ESG framework often results in decreased portfolio returns and alpha generation.
This should not come as a surprise. Integrating 17 UN Sustainable Development Goals and 169 related corporate targets into a firm-wide investment process can lead to a paralysis of analysis. Haranguing company management teams about esoterica eats up a lot of time, and only distracts from real fundamentals and market monitoring.
Rather than a regulator-mandated integrated approach that layers on administrative overhead across all funds—with no corresponding increase in management fees—higher margin segregated accounts would be the more appropriate means of satisfying the vocal minority of ESG-driven investors, many of which currently reside in Europe.
There is no shortage of impact-oriented capital looking for new sustainable investment strategies. Asset managers (European and otherwise) should compete for these mandates on a head’s up basis and make the case for their own proprietary approaches to ESG analysis, rather than forcing the entire global industry to conform.
However, such a customized response would not move the needle toward the stated goal of creating a “sustainable global financial system” by the year 2030, which is the point of the EU’s SFDR regulations.
Paul Tice is an Adjunct Professor of Finance at NYU Stern.