BlackRock, ESG and the evolution of ethical investing

ANALYSIS: Mike Even, FaithInvest's Director of Strategy and Investment Research, looks at how the landscape is changing for values-driven investing – including faith-based investors.


Note that in our articles we often use ESG, SDG or Ethical Investing as catch-all phrases for the incorporation of ethical, social, governance and environmental considerations in investing. We use Faith-Based Investing to speak specifically of faith-led efforts towards similar goals.


BlackRock, the world’s largest asset manager, recently announced it would ratchet up its efforts to influence companies in which it invests to act in more socially and environmentally responsible ways, and to pressure all companies to release far more data to help investors gauge this behavior.


Since BlackRock invests in so many publicly traded companies around the world (it controls nearly $9 trillion in investments), the potential impact of such an effort is huge.


Not surprisingly, BlackRock's announcement, which came in the shape of its CEO Larry Fink's annual letter to the world's CEOs, in which he called on all companies “to disclose a plan for how their business model will be compatible with a net-zero economy”, made headline news across the world.


But perhaps the most exciting aspect of BlackRock’s announcement is that it is just one indicator of the vast changes that the asset management industry is implementing to meet the needs of ESG/SDG/Impact Investors and, of course, faith-based investors.


In FaithInvest's formative days, CEO Martin Palmer would say to various religious groups: 'We know what you’re against, now let’s also invest in what you’re for…' 'What you’re against' was Martin’s way of referring to the 'exclusion lists'; portfolios excluding offending stocks were, at the time, the dominant way for faith-based investors to express their preferences.


But BlackRock’s announcement hints at the vast enhancements that are now available to faith-based investors that go well beyond “exclusions”.


The evolution of ESG


The investment management industry originally approached ethical investing guidelines as an overlay: 'We will run the portfolio just as we normally do – but we will try to tilt it towards (or away from) the ethical requirements defined by the client.'


This approach required very little thought or commitment from the asset manager, was limited in scope, and created a potential fiduciary challenge in requiring that the manager deviate from their 'best portfolio'.


Many asset managers today include ESG considerations directly in the investment process and company analysis. For example, a manager can include ESG considerations (are company factories exposed to global warming impact? Will social inequity create increased costs for the company in the future? Are ethical considerations likely to change demand for a company’s services?) when modeling each company’s future financial performance and risk.


The analysis may also focus on perceived regulatory pressures or legal challenges related to ESG issues – just to name a few. When done well, this analysis factors ESG considerations directly into each company’s projected financial and business success and can also impact the company-specific risk assessments.


Interestingly, if a manager believes such a process makes sense, s/he should use the ESG enhanced analysis for all clients and strategies – not just for clients requesting ethical-based portfolios.


A natural outcome of including 'ESG considerations' in company analysis is direct engagement with corporate management on these issues. Management engagement can start with data requests and ESG/business-related questions and conversations.


That focus, alone, automatically leads to greater transparency and accountability, and may create changes in corporate behavior. But engagement can also guide shareholder activism or indicate situations where divestment from specific companies is the best solution.


Since such engagement is driven by business considerations and presented in the language of the investment world, it can be more palatable and impactful than a purely ethically driven approach. Most importantly, few people have more access to corporate management than analysts and portfolio managers.


More sophisticated ESG portfolios


Beyond incorporating ESG consideration into the investment process and increased influence on companies, leading-edge asset managers have increased the sophistication of their portfolio construction.


A few years ago, ESG portfolio construction techniques would have implied either an 'exclusion list' of companies low-rated by an ESG service or a tilt towards 'ESG positive' companies as designated by the same service; these exclusions or metrics were often chosen by the client, with the ESG service chosen by the asset manager.


Today, when faced with two otherwise similar companies, the manager can choose the more ESG-appropriate of the two based on his own research and assessments. Because the manager’s understanding of ESG considerations on the company level will often be deep, these decisions can be made fully incorporated into the investment process rather than relying on the client-imposed list of the past.


As another example of heightened sophistication (or complexity), a manager may take into consideration where a company is today on ESG metrics, but also where it is going, by considering its positive or negative ethical momentum when making portfolio decisions, thereby avoiding purchasing a company in 'ethical freefall' or selling a company that is slowly improving its ethical standings.


Buying solution providers


Another reasonably new method of optimising the portfolio for ethical considerations is to invest in solutions providers or companies directly addressing some of the ESG problems. Like all other companies in the portfolio, solution providers must first look attractive as investments.


It is easy to imagine some of the possible companies that might fit into such an effort: in the environmental part of ESG – perhaps renewable energy-related businesses or de-carbonization solutions; for social solutions providers – perhaps educational companies that create opportunities in emerging markets or economically disadvantaged areas, banking and lending corporations that cater to disadvantaged communities or real estate development that serve specific social needs. The options are broad and fascinating, and the challenge is to pick solutions providers that also make for profitable investments.


Going beyond ESG


Beyond these new ideas and progress, many managers are trying to help 'outside the box'. The idea is to harness other aspects of the client-manager relationship to help the client achieve greater impact. This is the newest of these aspects and holds a hodge-podge of ideas. Some that we have heard:

  • Contribute some portion of management performance fees to client-directed charities;

  • Advise the client on non-investment considerations that increase impact (e.g. carbon offsets, charitable donations aligned with some investments);

  • Create investment opportunities that span both investment portfolios and charitable work for the client.

The logic behind these efforts is to use the portfolio for impact within certain risk/return limits – but enhance the impact beyond the portfolio with these external efforts.


All these new options sound like good news, and they are! Options are broadening, the industry is far more serious about the ESG space and the solutions are much more intellectually rigorous. But there are challenges.


No universal standards or metrics


First, this continues to be a new and evolving space: there are no universal ESG standards and no industry-wide agreed metrics. Measuring 'impact' is tough and understanding how different managers and different approaches may increase or reduce impact and performance and risk is challenging.


Second, assessing a new manager or new mandate takes on multiple levels of additional complexity. Not only do we still need to assess investment skill (can the manager add value and control risk?), now we need to assess the additional skills offered for ESG-related decisions (how useful are they? Is the manager committed and resourced to carry them out?) and to potentially choose between managers offering somewhat different solutions to the same challenge.


Third, the vast majority of resources and solutions focus somewhat narrowly on environmental metrics (notably on global warming and carbon) with some governance and fewer social considerations. That may be necessary right now, but it means that faith-based considerations that are not specifically about global warming will be harder to address.


Finally, all this new information and new effort simply add complexity to a world where risk and return are already demanding and complicated enough and where most asset allocators are struggling with limited resources and time.


In our next article, we will delve more fully into these challenges and discuss how FaithInvest will try to support you in the ever-evolving world of faith-based investing…


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