Why ESG Is No Alpha Strategy

Larry Fink, CEO of the world’s biggest investment manager with more than $10 trillion in assets, BlackRock, describes it as the “greatest investment opportunity of our lifetime,” But Tariq Fancy, who spearheaded sustainable investing at BlackRock before quitting in 2019, went public with his angst about why he felt ESG (environment, social and governance) investing was nothing but just a fad. “It was creating a dangerous placebo that was delaying government action, it was misleading the public, especially in North America,” Fancy tells Fortune India.

ESG investing is generally accepted as a holistic way of investing that ensures economic progress is entwined with positive environment and social outcomes. Yet, ESG remains a big black box around which the Street and rating agencies have made their own rulebook. From FY23 onwards, the Securities and Exchange Board of India has mandated the top 1,000 companies by market cap to include Business Responsibility and Sustainability Report or BRSR in their annual reports.

“ESG is just a newer version of what was defined as sustainability,” says Chaitanya Kalia, partner and national leader, climate change & sustainability services, EY India. “The Brundtland Commission coined the term — people planet and profit — and down the line, profit got changed to governance as investor focus increased.”

That’s showing and how.

Sustainable investing is gaining ground globally. CY21 was a record year with an estimated $120 billion flowing into sustainable investments, more than double the $51 billion seen in CY20. In fact, over CY18-CY20, these investments surged 10-fold. According to Sanjai Bhagat, Provost Professor of Finance at the University of Colorado, most investors across the globe are interested in clean environment, healthy communities, and good employment conditions. Back home, nine mutual fund schemes collectively manage over ₹11,000 crore in assets, with most funds having been launched a year back, except for SBI Magnum Equity Fund, which was renamed as an ESG fund in 2018 (See: As good as it gets).

For starters, Nilesh Shah, MD, Kotak AMC, believes India Inc has come a long way in terms of governance. “In the 2000s, a company such as HFCL would have been present in just about every other scheme, but today you won’t find such names in MF portfolios,” says Shah, a former fund manager who now heads the country’s sixth-largest fund house.

But in an emerging economy where governance is still evolving, how can E and S not be subjective? For instance, Shah mentions an instance when during a due diligence visit to a production unit, the company’s CFO took him to a tea stall that employed a small boy. The CFO told Shah, “If the kid is seen in the vicinity of my factory, ESG-focussed investors and clients will raise a red flag and blacklist my firm.”

For Shah, the observation was striking as to what constitutes “social” in the West has a different connotation back home. “Child labour is socially unacceptable in the West, but in Indian context, the grim reality is that small children supplement incomes for their families instead of going to school. I might end up depriving a kid of his existence if I were to blindly apply the ESG rules without contextualising them to suit Indian conditions,” he says.

While there is a difference of opinion about what constitutes ECG, investors are already asking India Inc questions, though most of it is environment related. For instance, according to CDPs 2021 non-disclosure campaign, 12 foreign investors managing $3 trillion in assets, including Amundi Asset Management ($1,630 billion), HSBC Asset Management ($478 billion) and Aviva Investors ($448 billion), are urging 39 Indian firms, including RIL, Asian Paints, Bajaj Auto, HDFC and ICICI Bank, to disclose their environmental impacts. CDP is a not-for-profit that runs the global disclosure system for different stakeholders.

According to CDP, 88 investor-requested companies from India have disclosed an aggregated climate related risk of ₹3.28 lakh crore. While India Inc’s climate-related risk is substantially huge, it also shows that firms are cognisant about the environmental risk that their businesses are being exposed to and are being pro-active about addressing it. Investors may have a very limited role in this case.

For instance, Bhagat in a research paper titled ‘Rule of law and purpose of the corporation,’ showed that managers trying to maximise long-term shareholder value will of their own accord prioritise employee, customer, community, and environmental interests. For example, around 69% of the 100 largest US corporations made drastic changes to their employee work schedules to safeguard employee health during the pandemic, 64% made significant changes to accommodate customer concerns about health safety and logistical convenience and 62% increased the size and scope of their contributions to communities. “These activities are clearly consistent with stakeholder priorities. Given the voluntary nature of these activities, managers must consider them consistent with the interest of long-term shareholders,” says Bhagat.

Not surprising that a study done by CFA Society India and CFA Institute on Indian ESG funds reveals divergence across funds when it comes to investment approaches, scoring methodology and outcomes. Shah believes the reason for this is that ESG integration practices are still evolving in the country. “ESG is not a unidimensional concept but a multidimensional one. On the governance front we are more capable, while on the environment and social aspects we will keep evolving. We can’t blindly copy the developed markets and need to contextualise ESG for Indian standards. We need to learn from global practices, fast-track some of them, modify the others and implement what is relevant to our markets,” feels Shah.

While globally and in India, companies will be forthcoming about their climate conscious efforts and will also link a part of the top management’s compensation to milestones being met under the Science Based Targets initiative — which defines best practices in emissions reduction and net-zero targets — it is still not clear whether the efforts will fetch better returns for investors. For instance, the Nifty ESG 100 sector leader is down 9% year till date (May 10) compared with 8% for the Nifty 100. One of the prime reasons that ESG focused and non-ESG focused indices returns mirror each other is because the top 10 stocks across both the indices are the same. For instance, the ESG indices have Reliance, HDFC Bank, Infosys, HDFC, TCS, HUL, Bajaj Finance and Airtel as stocks with the highest weightages, which is no different from the Sensex or the Nifty. In essence, investors really don’t have pure-play ESG stocks to play around with in India. Not surprising that the nine ESG schemes, too, are down an average 12% year till date (May 10) (See: All in the family).

Dhirendra Kumar, founder of Value Research, feels that instead of worrying about ESG, investors would be better off following the time-tested principles of buying fundamentally good stocks rather than of falling for themes. “At the end of the day, mutual fund is also a consumer product and needs a story spun around it — just like it was all infra in the past,” says Kumar.

Unlike in the West, where investors are still okay to live with lower returns, in India where inflation is a big concern, investors won’t fancy making peace with lower returns. According to the CFA Institute’s survey, 60% of Indian investors (sample of 200 retail and 75 institutional investors) cited higher risk-adjusted returns as the primary reason for investing in ESG funds! It is double that of the global sample of 29%, with only 30% citing personal values or a positive impact as the reason for investing in ESG funds.

Kalia points out that to assume that a company with an ESG rating will deliver higher returns is a challenge. “Measuring non-financial parameters such as ESG is difficult since it is intangible, and if an investor expects that the highest-rated ESG company will do well in a falling market, the answer is no.”

There is a reason for the minimal difference. “You are not seeing a significant return differential as even non-ESG stocks are moving in the same direction,” says Shah. Citing an analogy, he says, “I don’t need to rear a criminal in my family so that others can appreciate my ‘saint’ son or daughter.” In other words, a fund manager doesn’t need to invest in non-ESG stocks to show that ESG works.

But the current market meltdown is putting ESG funds through a pincer not just back home as globally, too, carbon-intensive energy and defence stocks have done well owing to the Russia-Ukraine conflict, compared with technology and financial stocks. While the benchmark and IT indices fell between 1% and 14% from February 24 to May 25, energy, utility and power stocks rose between 12% and 17%. Now, can investors be blind to the changing geo-political reality where energy self-sufficiency of economies would mean that conventional fossil energy firms will remain in vogue even as renewable players come of age?

Fancy’s belief is that financial investors cannot force the change and that it has to come from the government. “We’ve seen time and time again that relying on Wall Street and big business to “self-regulate” is a recipe for disaster…That has to be a systematic solution and can only come from government leadership,” mentions Fancy in an interview.

Fancy’s observations are not misplaced as for all the concerns around sustainability, investors will be finally focused on returns. With regards to businesses, Kumar feels they don’t need investors to tell them what to do. “Look at the country’s biggest thermal power generation company, NTPC. Today, it also holds the biggest portfolio of renewables. So, businesses change when the time is conducive.”

While there is no denying that ESG is here to stay, it is not a strategy that will fetch higher returns. Instead, investors should use it as a guiding framework for constructing a long-term portfolio.