ESG has been an incredible movement. It had seemingly unstoppable momentum and acceleration, and with good reason. Everyone wants to save the climate and work to treat employees, customers and communities with respect. All are for good corporate governance.
Nevertheless, in recent years many people, especially behind closed doors and in private conversations, have been skeptical about investments based on environmental, social and corporate governance factors. This skepticism about ESG investing has recently come to a head.
Why is this? That’s because there’s a huge disconnect between ESG as a philosophy and as an investment product. ESG is a conceptual idea of new factors that market participants should consider when investing in and managing companies. Many ESG mutual funds took this idea and used it as a marketing tool to add assets to strategies based on quantitative data and ratings that were easy to manipulate and far too passive to bring about real change. Additionally, there is a widespread perception, if not reality, that ESG investing means sacrificing returns.
Now, a bear market has exposed those weaknesses and, for the first time, the ESG investing movement has lost some of its momentum. Worse still, these disclosed flaws in ESG mutual funds have opened the door for funds to market themselves as the antithesis of ESG, advocate for the elimination of any social motivation towards companies, and completely disregard race and gender in hiring practices. This drastic response to ESG funds does on the right what it criticizes on the left: taking an extreme position that exploits the views of the far right to arm opponents of ESG funds, like many ESG -Funds were created to exploit and arm the acolytes of ESG. Ideological maximization of profits while ignoring social impacts will result in companies like Purdue Pharma or boards rationalizing potential oil spills through a cost-benefit analysis of potential fines and clean-up costs versus the costs of prevention. What about occupational safety? Should this be sacrificed when the cost of employee safety outweighs liability and the cost of replacing injured employees? Anti-ESG funds that are solely geared towards shareholder value would probably waive the costs and assume liability. Besides these anti-ESG funds, does anyone really think that a board or management team isn’t better off having qualified members with diverse perspectives and life experiences than just being white and male?
Of course, management teams and investors should consider environmental, social and governance factors, but these are factors that need to be weighed, not mandated. These decisions are more complex than either side acknowledges. They cannot be made quantitatively, with generalizations, or by extremists. They must be qualitative, by an active participant who weighs the pros and cons and pragmatically commits to a position that benefits all stakeholders, including shareholders. This is what active ESG investing, or AESG, does.
AESG investing is when an activist investor takes a position in a company and actively (usually at board level) and qualitatively analyzes and improves not only financial, operational and strategic aspects of the company, but also its ESG footprint. Funds like Inclusive Capital and Impactive Capital are leaders in this space, looking at every investment not just from a shareholder value perspective but also from an ESG perspective. In many cases, these funds champion ESG practices at their portfolio companies, which increase shareholder value. Other activists who are more focused on the operational, financial and strategic matters of their portfolio companies recognize that while they are actively involved in those companies, they are also in a unique position to improve ESG practices within the company. Accordingly, many of these funds, such as Starboard, ValueAct, and Third Point, have dedicated ESG executives to help focus on such opportunities. We see many more of them beginning to adopt such practices.
These AESG investors recognize that you cannot achieve ESG goals by investing in the “best” ESG companies and excluding the worst. Nor can they expect management teams to blindly adhere to ESG pressures, regardless of the impact they will have on shareholder value. Instead, AESG investors analyze ESG issues and opportunities, as well as the company’s finances and operations, to pragmatically develop strategies and practices that either enhance ESG and shareholder value, or enhance one without hindering the other.
Accordingly, AESG solves the problems with ESG investing because (i) it is real, not a marketing ploy, (ii) it relies on qualitative analysis rather than quantitative metrics and ratings, (iii) it uses engagement to actually create an ESG to effect change without compromising shareholder value, and (iv) it has the alpha historically associated with shareholder activism. Furthermore, AESG investors not only strive to change the ESG practices in their portfolio companies during their engagement, but also the long-term culture of the company, so that ESG is ingrained in management thinking as something to weigh and consider in all future business decisions must become .
ESG investing is a term that combines two concepts: ESG and investing. However, most mutual funds on either side of the debate tend to focus on just one of these concepts and ignore the other. Responsible ESG investing is not just being responsible for environmental, social and governance factors, but being a responsible investor for ESG factors and aiming for outsized capital appreciation. This is a key tenet of AESG investments.
Because there is a finite number of investors with the skills, attributes and inclination to actively engage in the management of portfolio companies, AESG investment strategies will always be a small subset of total ESG wealth. But it will be an increasingly important subset, and those who invest in AESG investing will add a much-needed active component to ESG investing to effect real change and generate real alpha. ESG investing is still a young strategy and will continue to evolve and evolve. As more activist managers begin to focus their efforts on ESG improvements, AESG becomes an important part of this evolution.
Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and he is the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist assets. Squire is also the creator of the AESG™ investment category, an activist investment style focused on improving portfolio companies’ ESG practices.