ESG Investing: What’s the big idea?

Back in January 2022, I wrote the following about the fervour for ESG investing – writes Joe Wiggins

“What happens when stocks and funds with positive ESG characteristics start to underperform? Investors are likely to move on to the next outperforming trend, particularly as we told them to focus on the performance prospects.”

 
That this scenario has unfolded does, unfortunately, not reflect some remarkable prescience on my part; it is just the grimly inevitable denouement that occurs after a compelling story is combined with unsustainable performance and ferocious asset manager marketing to create wholly unrealistic investor expectations. When the industry has its next big idea, investor disappointment often follows.

This has nothing to do with ESG as a concept. There are plenty of positive and worthwhile elements attached to ESG investing, but unfortunately many of them were forgotten because of the zeal that came to define it. The question here is not about the validity of ESG, but rather why such cycles of investor obsession occur.
 
There are three important observations about big ideas in investing:
 
1) Past performance dominates investor behaviour: Past performance is the overwhelming force driving investor decision making – it consumes everything we do, whether it be a private investor or the committee of an endowment. We might not like to admit it, but our views and decisions are indelibly shaped by recent returns. No matter how committed we might be to an investment approach, style or asset class, two or three years of underwhelming returns will be more than enough to shake us out of it. Strong performance fuels the big idea as surely as weak performance kills it.
 
2) Substantial inflows erode future returns: One of the most perverse elements of investors ploughing assets into the next big idea is the apparent ignorance that the flows must almost certainly push valuations higher and future long-term returns lower. We are attracted to robust recent performance despite it dragging returns from the future into the past. The next big idea always comes with wholly illogical performance assumptions.
 
3) Asset managers will sell things that benefit them and sell them aggressively: If asset managers are fanning the flames of the latest big idea then there is a very high probability that it is better for them than it is for us. This is an issue that has been made more acute by the rise of index funds and compression in active fund volume and margins. Good businesses solve client problems, bad businesses try to solve their own.
 
So, now that some of the froth that came to surround ESG investing has subsided, what’s the next big idea? It is difficult to be sure – something related to AI must be a strong contender – but perhaps private markets are the obvious candidate. The combination of high fees, long-term lock-ins, performance opacity and limited direct competition from passives makes them a perfect solution to many of the threats that asset managers are facing. It is unclear whether the benefits to clients are quite so significant.

It is not that big ideas are necessarily bad ones. Many of the tenets of ESG continue to bring welcome attention to important and neglected areas, and it is by no means unreasonable for an investor to hold an allocation to private markets as part of a diversified portfolio. The problem is when these ideas are taken to extremes. They tend to become ubiquitous, impervious to challenge and saddled with wildly irrational expectations. To make matters worse, any genuine underlying benefits from the initial idea get lost amidst the excitement and inevitable comedown.

So, where does the rise of index fund investing sit in all of this? Is that another problematic big idea? No, it is not the same. The key difference being that it is an evolution that has largely been resisted rather than embraced (for obvious reasons). It has succeeded despite it being against the interests of the industry. That being said as investors we are always complacent about concepts that are performing well and underestimate how we will react if the environment changes. Index funds will not be immune to this behavioural reality and we should not be complacent about it.

The simple truth is that the asset management industry needs big ideas more than investors do. All most of us need is small, simple ideas, consistently applied.
 
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