By Michelle de Cordova, Principal and Blythe Clark, Director, ESG Global Advisors
Responsible investment (RI) approaches have often been represented on a continuum from “valuation first” to “values first”. But does this accurately represent the scope and focus of RI today, and why is it important to clarify our terminology at a time of growing interest in – and polarized debate about – ESG?
Many of us will be familiar with versions of the “RI Spectrum” diagram, which typically represents the scope of potential responsible investment (RI) approaches as a continuum from “valuation first” to “values first” (see Figure 1). In this visualization, the emphasis on values increases along the continuum, with impact and thematic investing usually positioned as giving it the highest priority. In some versions, impact investing is positioned as just one step away from philanthropic giving.
Figure 1: Typical RI Spectrum
Does the RI Spectrum Accurately Represent RI – and Does it Matter?
Is the RI Spectrum still an accurate representation of the scope and characteristics of RI practices in the investment industry today? Specifically:
Are “valuation” and “values” really a continuum? While an ESG integration-only RI strategy can be assumed to prioritize valuation over values, the balance varies among different ESG thematic and impact strategies. Specifically, many ESG thematic strategies target market-level returns. In fact, the only RI approach that consistently prioritizes values over valuation when the two come into conflict is screening: if a potential investment does not comply with a positive or negative ethical screen, it must be excluded.
How much does ESG thematic investment differ from traditional strategies focused on a specific opportunity, which have long been investment industry staples? We have already noted that ESG thematic strategies are not by definition “values first”. While an ESG thematic approach will certainly result in a constrained universe of potential investments, the same can be said of traditional investments in small-cap equity, emerging markets, and natural resources. In all these cases, investors pursue a specific opportunity, accepting any increased risk associated with a less diversified or more volatile universe, in pursuit of enhanced returns. The fiduciary duty to pursue “valuation first” does not mean that a small-cap equity strategy will switch to mega-cap stocks during a period when small-caps are performing poorly. That being the case, in principle, if an ESG thematic strategy matches an investor’s risk and return expectations, why should it be considered less suitable in the context of fiduciary duty than any other investment focused on a specific opportunity, just because that opportunity happens to be ESG-related?
Is an RI approach still “values first” if it is a mandatory requirement? In the past, adoption of RI approaches was voluntary, or driven by client demand. A new phenomenon, impacting both “valuation first” and “values first” strategies, is the emergence of regulatory expectations for investor responsible business conduct, from requirements to report on the principal adverse impacts of portfolio investments under the European Union Sustainable Finance Disclosure Regulation (SFDR) to laws banning investment in cluster munitions. Even traditional investment strategies that have not otherwise adopted RI approaches may be required to follow these rules.
A Broader View of Thematic Investing According to MSCI, “thematic investing is characterized as a top-down investment approach that capitalizes on opportunities created by macroeconomic, geopolitical and technological trends. These are not short-term swings – but long term, structural, transformative shifts.” MSCI’s thematic indexes cover not only typical ESG themes such as renewable energy and water, but also technology, healthcare and demographic themes.
Does it matter if the typical RI Spectrum diagram doesn’t fully reflect current RI practice? We think it does, for two reasons:
If investors bound by fiduciary duty assume that all ESG thematic and impact investment strategies prioritize values over valuation, they could miss out on opportunities that are consistent with their investment beliefs, risk appetite, and legal responsibilities. Accurately differentiating the objectives of different strategies could open the field for investment in profitable ESG-related opportunities, especially for fiduciaries.
Increasing positive interest and fund flows into ESG have created legitimate concerns about green-washing, which can be attributed in part to confusion about RI definitions: disappointment is sure to follow if product RI characteristics are misaligned with client RI objectives. Better articulation of RI approaches might also help to calm some of the current negative backlash against ESG, at least to the extent that this arises from genuine misunderstanding of the difference between RI approaches that seek to influence environmental and social sustainability outcomes, and those that simply respond to the potential for material ESG factors to impact valuation.
Reimagining the RI Spectrum
With this is mind, we have reimagined the RI Spectrum (see Figure 2), considering the following aspects:
Is the investment universe constrained by the RI approach, and if so, how and why?
Is there a focus on value creation from ESG opportunities?
Are sustainability impacts and outcomes measured, and if so, are specific goals set?
At a time of growing interest in – and debate about – ESG, clarifying the definitions of RI approaches has never been more important. Better articulating the RI Spectrum might open new ESG opportunities for fiduciaries and even help to bridge at least some of the gap between ESG proponents and sceptics. But however we may visualize the RI Spectrum, and whether an investor focuses on valuation, values, or a combination of the two, we believe the following steps are critical to establishing an effective RI program that can stand up to any kind of scrutiny:
Capacity Building: Ensure that key stakeholders and decision-makers have a common understanding of potential RI approaches (sharing this piece could be a way to get started).
Strategic Positioning: Understand the RI landscape for the investor’s type, determine where the investor is currently located in the landscape, and achieve consensus on the investor’s level of RI ambition.
Policy: Develop RI policy appropriate to the investor’s type and RI ambition level.
Implementation: Put in place RI frameworks and processes that allow effective implementation of policy.
Reporting: Monitor RI implementation using appropriate metrics and targets, and report on progress in alignment with established disclosure frameworks.
Need help getting started with RI? ESG Global offers customized services for investors (asset owners and asset managers), with portfolios of different sizes and across asset classes. Visit Our Services to learn more.