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ESG: Complex in a Vague Sort of Way

May 20, 2023

By Mike Sebastian. Mike has served as Chief Investment Officer at Aon, and at fintech firm NextCapital.



Amid widespread confusion about ESG and impact, Mike Sebastian offers his thoughts on what asset owners can realistically achieve with their investments.

Do you know of another $35 trillion (or $18 trillion or $46 trillion, or another number depending on whom you ask) collection of assets for which no one can seem to agree on the basics?

Here in the US, "green" and "anti-woke" politicians battle it out over public pension investments, while three-fourths of pension participants can't say what "ESG" is supposed to stand for. (The popular vote winner: "Economic Stock Growth.")

Among the investment experts, discussions of ESG investing tend to be a combination of complex and vague. This reflects the need to juggle the motivations and rationales of different groups:

  • Activists want to create change, working with and through the investment industry, politicians, and media, in whatever way is deemed most effective at advancing goals.
  • Investment managers and consultants want to provide their expertise, products, and services to asset owners, to help their clients and grow their own assets and revenue.
  • Pension plan participants, employees, university students and other stakeholders have a mix of financial interests and non-financial concerns about how the asset owner acts.
  • Asset owners (such as pension plan sponsors) need to balance their mission and duty with the above, and with their own values—and are, in a sense, caught in the middle.

An open secret: sustainable investing without impact

Critically, activists and investment service providers generally understand, though don't often say loudly, that impact (the 'good' part of 'doing well while doing good') is unlikely to be directly achieved through most investment choices.

Buying and selling securities in the secondary market doesn't directly affect companies, and academic research suggests limited-to-no impact on cost of capital. As an example, an influential recent study found minimal impact of divestment strategies to date on corporate cost of capital, and that 86% of the world's investment assets would have to adopt ESG motives to impact aggregate cost of capital by 1%.

This isn't news. The UN Principles for Responsible Investment – citing, among other support, the general conclusion of research studies – indicates that divestment has limited-or-no direct effect on individual companies' decision making.

"Impact (the 'good' part of 'doing well while doing good') is unlikely to be directly achieved through most investment choices."

In the US, CalSTRS, one of the leading global practitioners of sustainable investing, indicates that "divestment would be likely to have negligible impact on portfolio companies or the market".

Now, some may argue that divestment is an outdated concept, and that positive screening (include or overweight good stocks) or ESG integration strategies are better approaches. But divestment is nothing but an extreme version of tilting away from a bad stock and is the mirror image of positive screening or tilting toward a good stock. One can't overweight something without underweighting something else.

So, improving your portfolio's ESG rating or carbon footprint isn't likely, on its own, to make something happen that wouldn't otherwise have. (This would be equally true for "anti-ESG" type strategies that focus on, say, fossil fuels.)

This simple assertion turns a lot of responsible investing on its head. It calls into question the 'doing good' rationale, at the same time as asset owners consistently offer non-financial goals at, or near, the top of their reasons for pursuing ESG.

A way forward

All is not lost, though. Asset owners should find the intersection of what realistically can be accomplished in ESG with what, if anything, they want or need to accomplish, and avoid being led to an unsuitable course of action, product or service.

It is ambiguity and conflict about goals, along with an unrealistic view of what can be achieved, that hinders or damages many responsible investing efforts. Following are some realistic potential goals and actions for asset owners.

Align with your, and your stakeholders', values

Ethical alignment of your portfolio with a set of values, without expecting impact, is an achievable goal.

This goal can be beneficial for organizations (faith-based, social, etc.) where promoting values is a core part of the mission, and it may help with satisfaction and engagement of employees and other stakeholders.

It's reasonable to expect most intentionally values-aligned investments to provide a market-like return, all else being equal, before costs (which should be minimized).

For example, probably the most widely used world equity ESG index has closely tracked the returns of the broad market in each of the last 14 years, which is consistent with the goal of alignment with values at no expected performance penalty (if done with low cost, such as through rules-based investments.)

Well, if not always good

ESG factors are, and will be, important in portfolio management, given the physical, economic, consumer behavior and regulatory impact of E, S and G.

The skilled active managers you use should be expected to reflect ESG-type data in their investment processes, purely as part of their goal of maximizing their risk and return results (aiming for 'well', not 'good').

"It is ambiguity and conflict about goals, along with an unrealistic view of what can be achieved, that hinders or damages many responsible investing efforts."

80% to 100% of managers claim to integrate these factors already, so there may be a finite opportunity for improvement.

Success here is measured by alpha, information ratio and other investment measures, not responsible investment statistics or ratings, as the portfolios won't necessarily score well on ESG. Measuring integration results with ESG metrics is an alpha (and alignment) warning sign.

Asset owners should also incorporate climate change risk and return scenarios (including potential regulatory impact) in their asset allocation review processes.

Impact through influence, engagement and... consumerism?

Large, prominent investors, or those who can organize in like-minded groups, may be able to influence other investors, consumers, and regulators by communicating publicly (signaling) about their investment actions (e.g., divestment.)

Just as negative political advertisements are common because they work, seeking to stigmatize firms that differ from your values is likely the most effective approach, if perhaps not to everyone's taste.

Asset owners can vote proxies (in separate accounts or where the fund manager allows investors to direct votes) in line with their values, and/or otherwise engage as a shareholder with companies that they invest in and want to change. (The recent move by some investment managers to allow index fund shareholders to participate more in proxy voting is a welcome development and may help with some of the political battles occurring in the US and eventually elsewhere.)

Unlike most investors, consumers have an immediate and direct impact on businesses. Asset owners, as consumers of investment management and other services, can leverage their buying power, if they wish, by directing it toward firms that share their values, or create impact by allocating assets to emerging/diverse investment managers.

Lastly, direct impact by asset owners through investment choices is possible, typically through private investments (funding renewable energy projects, affordable housing, microlending, etc.)

Discussions of ESG can be complex, confusing, and controversial—but they don't have to be. Investors: ignore how others suggest you think and act and review your investment options through a realistic lens to achieve your own organizational mission and goals.

Link to full paper in Environmental Finance

About the Author:

Mike Sebastian has over 20 years of experience in investment management and consulting, working with a wide variety of investors globally, leading large teams, and driving forward innovation in investment strategies and processes.


Mike has served as chief investment officer for Aon and at fintech firm NextCapital. Mike has authored notable practitioner research in investment topics, developed innovative methods of analyzing and constructing investment programs at large scale, and is active in his community.