The ESG Integration Paradox

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous. Yet, a written policy is not a reliable indicator of a firm's commitment. Actual ESG incorporation practices vary greatly, with most investment managers falling well short of full integration. Only a few firms seem to be using ESG factors to deliver alpha, hence, the paradox. If not implemented wholeheartedly, responsible investing can lead to lower financial returns. So, why have so few investment managers gone all the way? The paradox involves a “valley” of lower returns where portfolios first absorb the costs of ESG integration before the promised benefits materialize. In the early days of ethical investing, the focus was on using negative screens to exclude certain companies for moral or ethical reasons but lower financial returns are inherent to exclusionary screening. Hard exclusions force managers to tradeoff certain risks for others. So, for example, if the market discounts tobacco stock prices to account for changing consumer behavior, eventually tobacco stock prices become attractive again as, indeed, has been the case over the last two decades. Exclusionary screening alone is a self‐limiting strategy. By contrast, ESG strategies range from active ownership and engagement, to positive screening (selecting for certain attributes), to relative weighting (sometimes called “best‐in‐class selection”), to risk factor investing, to full integration. Because the relationship between an asset manager's ESG efforts and its risk‐adjusted performance is not classically linear, asset owners should look for managers that are on the upward slope of the ESG intensity curve and are fully committed to advancing up it.