In the span of a year, ESG—a three-letter acronym for environmental, social, and governance—has become a four-letter word in parts of the world. ESG factors have been widely used as a set of criteria in a manager’s risk assessment toolkit, just as financial statements and economic reports are. However, over the last year, the term ESG has been coopted. The acronym has taken on a pejorative connotation that suggests ESG factors require a tradeoff between returns and supporting a political agenda. We think now is the right time to remind all stakeholders of our view on ESG integration.
Understanding Risk is Part of the Job Description
We balance many complementary objectives as an investment manager: our fiduciary duty to clients, our obligation to seek the best long-term, risk-adjusted returns on their behalf, and to keep our behavioral biases in check as part of our commitment to value investing. In our opinion, integrating ESG factors into our investment research and analysis helps us fulfill these mandates. Much of our global client base has expressed interest in understanding how we incorporate environmental, social, and governance factors into our investment research and analysis—with many of these clients based in the U.S. They want to know how we’re thinking about ESG-related risks with respect to their portfolios; we’ve seen their questions and interest in ESG integration have grown more sophisticated, nuanced, and prolific over time.
There was no shortage of complex ESG risks in 2022, from the invasion of Ukraine to food and energy price inflation. However, with the contention surrounding ESG in the U.S., the country serves as an interesting backdrop to illustrate how these factors come into play. For example, the U.S. Inflation Reduction Act (IRA) is a piece of legislation that presents risks and opportunities at macro, sector, and fundamental levels. Our job is to remove any political biases and think about who the “winners and losers” of the IRA could be, what the long-term fiscal and economic implications may be, and how we might want to account for those themes in our portfolios.
Having a Seat at the Table
Active management highlights how ESG factors and risk are related, and introduces another effective investor tool: engagement. In order to have access to management teams and government officials, managers often have to either be providing capital or be very close to doing so. Participating in a dialogue with management teams and government officials provides investors with an opportunity to ask questions, understand planning and outlooks, and determine whether their story matches ours.
Engagements also provide a chance to gauge reactions from the C-suite and government officials; an unwillingness to participate in a discussion, identify a risk, or acknowledge structural changes could be red flags. To put this concept into traditional terms, we could reconsider our thesis if a central banker rebuffed our questions on rate hikes when inflation was running rampant, or if a CFO balked at a question about raw material inflation, rising costs, and eroding margins. Our aim is not to judge whether a CEO or treasury secretary believes in the value of ESG. What matters to us is how these leaders account for the economic and financial conditions that may be related to these factors.
For investors, there is always the risk of being too early, too late, or making the wrong call. In our view, making the wrong call with respect to ESG can sometimes mean excluding certain sectors based on these considerations alone. As an example, nuclear energy producers have been subjected to broad investor exclusions. Now that nuclear energy is experiencing a renaissance, investors that maintain these exclusions may lose out on potential upside. These exclusions sometimes overcompensate for short-term sentiment rather than account for a long-term structural view. We believe this thinking applies to the oil and gas sector, too. This industry is on the precipice of innovation, and we feel that to broadly exclude it would be a disservice to our process and to our clients.
We need to strike a balance between being risk aware, thoughtful in our portfolio implementation, and meeting our clients’ needs. This is why we find organizations like Climate Action 100+ and the Institutional Investor Group on Climate Change are important, because they provide pragmatic guidance on how to think about these industry exposures within the context of ESG themes like transition risk. While some big industry names involved in passive funds and ETFs may be distancing themselves from these initiatives, we find these memberships additive to our information risk assessments.
Follow the Capital
From our vantage point, ESG factors are part of the global risk complex and if left unaddressed, may have a material effect on asset prices. Ultimately, we believe capital flows will decide if ESG factors maintain their place within our industry, whether it is determined by flows into funds, indices, asset classes, financing, or innovation. Until then, as the investment management industry grapples with ESG’s definition and utility, we will continue to evaluate these factors on a qualitative and quantitative basis for many of our clients and strategies.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.