Is ESG a risk to fiduciary duty? | Index One
In this edition of Index One , we ask the longstanding question: is ESG a risk to fiduciary duty?
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Is ESG a risk to fiduciary duty? | Index One
Where do we draw the line between ESG responsibility and fiduciary duty?
In 2023, sustainable equity funds exhibited the most robust performance among asset classes, boasting a median return of 10.9%, surpassing the 8% return of conventional equity funds. The outperformance in fixed-income investments was comparatively more modest, with sustainable funds delivering a median return of 3.8%, while traditional funds achieved a return of 2.2%.
During the first half of the year, sustainable funds accumulated inflows totaling $57 billion, with the majority of these investments directed towards Europe. This influx raised the assets under management (AUM) to over $3.1 trillion by the end of June, representing nearly 8% of the total global AUM. However, it still fell short of the record achieved in 2021.
Despite the underperformance of sustainable funds in 2022, there was strong investor interest and demand for sustainable investment opportunities. Sustainable funds constituted a record-breaking 7% of the total AUM, even as traditional funds experienced outflows of $565 billion by year-end. Sustainable funds attracted net positive inflows of $115 billion, indicating robust demand from asset owners for sustainable products and strategies.
Sustainable funds have demonstrated greater resilience during economic downturns. Investors can employ sustainable and responsible company practices as an additional screening criterion when constructing their investment portfolios.
The downsides of ESG funds
Despite investors' willingness to prioritize ESG (Environmental, Social, and Governance) outcomes over financial returns, research indicates that sustainable funds don't consistently deliver strong ESG performance. A study conducted by researchers at Columbia University and the London School of Economics compared the ESG track record of U.S. companies in 147 ESG fund portfolios with that of U.S. companies in 2,428 non-ESG portfolios. Surprisingly, they found that companies in ESG portfolios had poorer compliance records regarding labor and environmental regulations. Furthermore, the study revealed that companies added to ESG portfolios did not subsequently improve their compliance with labor or environmental regulations.
Several factors may explain why ESG funds are not performing well:
Redundancy of ESG Focus: One explanation is that an explicit focus on ESG may be redundant. In competitive labor and product markets, corporate managers striving to maximize long-term shareholder value should naturally take into account employee, customer, community, and environmental interests. Thus, setting specific ESG targets may distort decision-making rather than enhance it.
ESG as a Cover for Poor Performance: Some evidence suggests that companies publicly embrace ESG as a way to divert attention from poor business performance. A recent study by Ryan Flugum of the University of Northern Iowa and Matthew Souther of the University of South Carolina found that when managers underperformed earnings expectations set by analysts, they often emphasized their focus on ESG in public statements. However, when they exceeded earnings expectations, they made few, if any, public statements related to ESG.
Consequently, sustainable fund managers who invest in companies touting ESG principles may be overinvesting in financially underperforming companies.
Greenwashing
It is not a reach to consider then that the consequence of forcing ESG into funds aiming to yield high returns is an increasingly common phenomenon called greenwashing.
Greenwashing typically manifests in two primary ways. First, a fund management team may assert that they are conducting in-depth, non-financial ESG analysis of potential investee companies, which, in reality, exerts minimal influence on their investment strategy. Alternatively, they may invest in companies that profess to have a positive impact but, in practice, fail to substantiate these claims.
Where do we draw the line?
Perhaps there is a better way to fulfill both ESG responsibilities and financial duty towards their clients without compromising on each. One of the most important fiduciary elements to consider is the investment process. When integrating ESG into the investment process, fiduciaries must measure and manage for risks that are introduced to the portfolio to ensure that ESG is an effective practice or, at the very least, costless.
In our previous webinar with Blue Tractor, we delved into papers published by Index One and The University of Illinois around costs associated with index front-running.
How much are you losing to Index Front-Running?
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Excerpt from Index One’s white paper about Index Front-Running:
In order to study this effect, we used the Index One platform to backtest two indices which closely reflect the Russell 1000 index (called US 1000) from January 2012 to December 2021, and rebalanced the first index a week before the original rebalance date, and rebalanced the second index a week after.
The table shows the US1000 Early vs Late Rebalance and their Difference in Index Value. The rebalancing dates for Russell 1000 was taken from FTSE Russell’s website.
The data shows that there's an average 7.6 basis point loss per year due to rebalancing inefficiencies. For a passive fund management industry size of $15tn AUM, this percentage translates to about 11 billion USD per year lost to index front-running.
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1 年Absolutely fascinating topic! ?? Exploring the intersection of ESG and fiduciary duty is crucial in understanding the evolving landscape of financial responsibility. Your commitment to delivering insightful content in Index One is commendable. Keep up the great work! ??