Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why greenwashing stains (and won’t wash out)
Regulators won’t be able to scrub out environmental, social and governance (ESG) ‘greenwashing’ in the investment industry, according to influential US finance academic, Aswath Damodaran.
In a blistering attack on the ESG investing sector last month, Damodaran says greenwashing – or falsely marketing funds as sustainable (or the like) – is an indelible feature of the score-based ranking system.
“There is probably no phenomenon on which there is more handwringing among ESG types than ‘greenwashing’, where companies substitute ‘looking good’ for ‘doing good’. Those complaints, though, ignore an unpleasant truth, which is that greenwashing is exactly the outcome of making ESG a system of scores and rankings,” he says.
“I am willing to take a wager with any ESG true believer that the more ESG services and regulators try to crack down on greenwashing, the more ubiquitous and sophisticated it will become. The largest and most profitable companies will have the resources to game the system better, exacerbating biases that already exist in current ESG scores.”
In a wide-sweeping critique, the New York University finance professor argues the recent Russian invasion of Ukraine exposed fatal flaws in the ESG concept that have split proponents into three separate camps.
The revisionists – who claim ESG investors were less exposed to Russian securities; expansionists – who used to the crisis to push for a broader definition of ESG risks; and utopians – who believe “the problems with ESG come from it being misappropriated, mis-measured and misused, and in their view, ESG, done right, will always deliver its promised rewards”.
Damodaran says those using the Russian example to expand the ESG data empire beyond its current corporate borders and into the country-based political realm face an impossible task given “those risks are in the eyes of the beholder”.
“Taking a bigger picture perspective, using the benefit of hindsight to keep expanding ESG to include the missed variables in each crisis will lead to measurement bloat, as it grows more tentacles and adds more dimensions,” he says. “Ultimately, if ESG tries to measure everything, it ends up measuring and meaning nothing.”
Echoing earlier comments by former BlackRock responsible investment insider, Tariq Fancy, Damodaran says the ESG agenda has been hijacked by “well heeled entities with agendas”.
“… I am convinced that there will soon be room for only two types of people in the ESG space,” he says.
“The first will be the useful idiots, well meaning individuals who believe that they are advancing the cause of goodness, as they toil in the trenches of ESG measurement services, ESG arms of consulting firms and ESG investment funds. The second will be the feckless knaves, who know fully well the void behind the concept, but see an opportunity to make money.”
But in a counter-argument published last week, Adam Fleck, Morningstar director ESG equity research, says Damodaran ignores a “third group” of investors “who want to better incorporate E, S, and G data into their analysis and aren’t prioritizing ‘saving the world’ in their investment holdings”.
“This group is focused on valuation of its investments, rather than expressing its values in its investments – the latter being a secondary consideration to the former,” Fleck says.
He says such investors are looking to ESG data for useful valuation signals while clearly distinguishing from what “needs” to happen from the most likely outcomes.
“For a more sustainable future, science will prevail, corporations will successfully balance the fine line between shareholder and stakeholder capitalism, and externalities (like carbon prices) will be fairly shared as internalized costs by consumers and investors alike,” Fleck says.
“But, as investment professionals, we must always focus on what is most likely to happen; that is, what has the highest probability of occurring? In this case, the judgment should not be focused on good versus bad but on separating the ideal future and the likely future – perhaps a cold truth, but a pragmatic one.”
