How Green Are Your Sustainable Strategies?

Today’s post is from Sarah Hargreaves, an investment management analyst on our Investment Management and Research team.

The recent demand for sustainable products reflects investors’ desire to allocate capital in ways that address or promote timely environmental or social concerns (e.g., the transition to a low-carbon economy, diversity and racial equity initiatives). With this in mind, let’s assess the current sustainable investment landscape, as well as the impact of this increased demand on greenwashing—or the process of falsely conveying, or providing misleading information about, a company’s products or services as environmentally friendly.

ESG Product Adoption on the Rise

The sustainable investing landscape looks promising, with nascent demand and growing adoption by the investment community. As of June 2021, assets in sustainable funds topped $304 billion—a 14 percent increase over the previous quarter—soaring well above the prior record of $159 billion from one year ago, according to Morningstar data. Active sustainable funds attracted the lion’s share of new assets throughout the first half of 2021. But adoption of passive environmental, social, and governance (ESG) funds, primarily exchange-traded funds, also continues to steadily increase, as investors seek ongoing tax efficiency.

Asset Managers Embrace ESG

In response to investors’ burgeoning appetite for ESG solutions, a growing number of asset managers have embraced formal commitments to sustainability—both at the corporate level and through their investment strategies. In fact, many traditional asset managers are now enhancing their product lineups by either launching new ESG strategies or repurposing existing funds to integrate an ESG focus.

At the end of 2020, more than 400 sustainable and ESG open-end and exchange-traded funds were available to investors. Between new product offerings and repurposed funds, the total number of sustainable open-end and exchange-traded funds topped 437 in the second quarter of 2021, with 25 new funds added to address timely concerns of investors (e.g., water treatment, women’s leadership, and diversity and inclusion), per data from Morningstar.

Does an ESG Label Tell the Full Story?

With assets, demand, and newfound commitments to ESG on the rise, one may think investors are well-positioned to navigate the sustainable investing space, one step closer on the path to a cleaner and greener future. But a current challenge for investors is differentiating between the established, reputable ESG strategies and those that are misleadingly positioned as more “sustainable” than they actually are. Although greenwashing can exist in many forms, a common example is when asset managers or companies misleadingly promote their products as ESG-focused, in order to garner additional assets or capitalize on investor interest. But simply labeling an investment strategy as “ESG aware” does not equate to materially integrating ESG criteria into the investment decision-making process or leveraging ESG criteria to identify inherent risks or opportunities for a company.

The rapid explosion of ESG strategies coming to market, coupled with a lack of standardization across ESG data and taxonomy, means the need to conduct thorough due diligence when vetting ESG strategies is more prevalent than ever. Investors would be well-advised to take fundamental research one step further by proactively engaging with management teams to discern a manager’s process, framework, and intentionality when assessing ESG issues or identifying best-in-class opportunities.

In addition, while data uniformity is sorely needed in the industry, leveraging reputable third-party data from reliable sources (e.g., Morningstar, Sustainalytics, MSCI, As You Sow) will help validate the credibility of an ESG strategy or manager’s commitment level. Furthermore, assessing key ESG scores (e.g., ESG risks, integration, or engagement) will allow investors to scrutinize a team or company’s engagement efforts while differentiating between effective ESG products and those that only scratch the surface.

Commonwealth’s ESG Due Diligence Process

At Commonwealth, the Investment Management and Research team adheres to a consistent, rigorous due diligence process when evaluating the universe of ESG funds and managers. We leverage quantitative and qualitative factors to help guide our decision-making. At the same time, we build on our core process to ensure that ESG managers under consideration are intentional and adhere to more stringent ESG standards.

Although our team relies on third-party data as a guiding input, our qualitative analysis enables us to identify the key players that live up to the high standards of ESG investing. Our discussions with portfolio managers allow us to garner a better sense of a manager’s objective, framework for ESG integration, and consistency in the process. We also try to identify the team’s history of implementing ESG criteria, as well as shareholder engagement, proxy voting, and impact or advocacy opportunities. Our team has been applying and refining this process for well over a decade, and we are well-positioned to assess ESG investing solutions and discuss those available to you at Commonwealth.

Look Under the Hood

While the proliferation of sustainable strategies and commitments ultimately translates into a greater number of offerings to choose from, investors should carefully discern between credible ESG integration and greenwashing attempts. By conducting thorough due diligence and looking under the hood, investors can avoid the pitfalls of greenwashing in their investments.