The wealth management industry is continuously changing. As we have seen over the last few years, active management is falling out of fashion and has become less ‘fashionable’ with asset allocators every year this millennium. In the last decade since the global financial crisis, we have seen the relentless expansion of the passive management industry and a consumer base that is more cost-aware than ever before. The king of passive management, Vanguard, is now the largest asset manager in the world and its relentless growth and outperformance of its peers (both in attracting assets under management and in investment returns) continues. The firm has always been the parent of both passive and low cost solutions in asset management and this has had dramatic effects on the industry. As it looks to defray cost pressure, areas of asset management where cost pressures are weaker are of note to the industry.
There is indeed one area of active management that is expanding dramatically, and with less pressure on fees, and this is ethical- or values-led investing. In financial jargon ethical investing is often known as ESG (environmental, social and corporate governance) or SRI (socially responsible investing). ESG has now become the most used term to represent an investment methodology that incorporates risk, return and social outcomes, replacing the previously popular SRI. ESG is predicted to grow at 15% a year for the next few years and how ESG frameworks develop should be of interest to anyone who is concerned about the environment or interested in the investment industry.
What does ESG represent?
- The E in ESG represents the environment, including the externalities, both negative and positive, that an investment decision can create. For example, the energy and waste used by an investment, the resources it needs, and the environmental consequences. Of particular note, environmental criteria include carbon emissions, with reference to likely effects to climate change. Depending on the evaluation methodology, carbon emissions are sometimes considered as negative, in other frameworks the marginal change in carbon usage is more important. Underlying every investment decision, every allocation of capital uses energy and resources, and this in turn affects the world we live in.
- The S represents social factors. The social definition can often be a bit loose, but generally it looks to factors relating to an underlying investment’s impact on society and the broader community. For a firm this could refer to working conditions, health and safety, human rights, diversity and inclusion.
- The G represents corporate governance, and principally relates to oversight and stakeholder management. In a well-run business, stakeholder incentives will align with the business’s success. Governance describes the controls and procedures by which a firm is managed and meet the needs of stakeholders. Often with particular reference to the interests of investors / owners vs the executive class and the broader workforce. All organisations can benefit from strong governance. It is hoped by ESG focused investors that by finding well-run companies you can create better social outcomes as well as enjoying superior returns.
Slowly but surely all the largest investment houses are creating and expanding their ESG teams, and they are doing this hand in hand with regulatory support — with global regulators looking to ‘nudge’ investments into socially superior outcomes and requiring additional detailed reporting to better analyse the environmental consequences of an investment manager’s capital allocation.