Hardly a day goes by without a pitch deck for a new impact investing fund or environmental, social and governance, or ESG, investment strategy landing on my desk. While I’m excited by the fast growth of products and service providers in the space, I worry constantly about the reputational risk to the industry should these perform poorly, especially during the inevitable next recession.
The extraordinary growth of values-aligned investing over the past ten years has been aided by a strong tailwind in the form of the longest bull market in US history. With a growing number of indicators pointing towards the coming end of the business cycle, it’s worth considering how ESG and thematic impact investing strategies will fare during the next recession.
Building on the earlier generation of negative screens, the integration of environmental, social, and governance (ESG) factors into investing strategies has taken center stage in values-aligned investing in the public markets, alongside shareholder activism.
The common denominator amongst many of these strategies is their short track record. Most ESG products, and especially passive and quasi-passive strategies riding the ETF wave, were launched within the last ten years and have therefore yet to be tested in volatile markets. Sure they are backtested, but the lack of historical reporting from companies on ESG factors compounds other known limitations of prediction, namely, past performance does not guarantee future returns.
In a perfect world, a market correction would prove the hypothesis that ESG factors are an effective risk mitigation tool. ESG however is more strongly associated with longer term risk management. The short term financial implications of selecting best-in-class ESG performers are still being understood. We saw this recently when products that excluded Facebook because of data privacy issues underperformed for several years, only to be validated by a series of scandals.
In a market correction of the type we saw in 2008, all public securities move down together in lock-step, or in investment speak, correlations go to one. This means that even the products with the strongest ESG integration may go down with the rest of the market. We are already seeing this in the bond market, where green bonds are suffering from the same macro trends that are hurting vanilla corporate bonds. Poor performance is especially likely if the strategy suffers from weak financial underpinnings — a risk that increases with the growth in the number of ESG products.
To critics, underperformance of ESG strategies during a down market would be another affirmation that values-aligned investing is associated with below market-rate returns. Every nay-sayer in every investment committee or legacy financial institution would have additional ammunition to try and shut out ESG.
Lastly, the ESG space is vulnerable to investor behavior. In times of financial uncertainty, we often observe risk-on, risk-off behavior, as investors flock to investments they perceive as safe in lemming-like packs. ESG’s short track record would make it a likely candidate for a sell order. While an exodus from ESG strategies is unlikely to affect stock prices, the relatively small assets under management and trading volumes of ESG products, especially ETFs, raise concerns about liquidity. Struggling to dump a small position of a thinly traded ETF in a quickly deteriorating market is not an experience one forgets easily.
There is no easy fix to these challenges. A call for financial rigor is unnecessary, but an appeal for greater attention to risk management in light of macro indicators is merited. Managers need to be prepared for volatility and work to address liquidity concerns. They can do this by engaging investors in dialogue around what to expect and how to react to a down market.
Private market strategies are safe from many of the threats facing their public markets counterparts. For one, most have long lockups, though even these are not a panacea. Recent years have seen a push by private equity funds to raise large funds before the end of the business cycle, funds that will carry them through the recession. However, in a down market, investors may not have the liquidity to make the required capital calls, or worse, they have to sell public equities to raise the capital, as we saw in 2008.
At the same time, we can expect a slowdown in capital flowing to new funds. This is again a demonstration of risk-off behavior; in times of uncertainty, investors will hesitate to lock their investments into funds with long horizons, especially in sectors that are considered more risky. The argument that impact investments, especially those in the developing world, provide an uncorrelated return, while perhaps true, has been slow to take hold even in stable markets. We can only hope that volatility and low returns in other asset classes will drive investors to seek out value-creating investment strategies in the impact space.
A recession would also affect the broader values-aligned investing industry in myriad ways. First, investment advisors will come under increasing pressure to demonstrate financial returns. A down market will test the risk management strategies of all players in the space and give strong advisors the opportunity to stand out in a manner that was not available in the long bull market.
An interesting feature of the values-aligned investing industry is its heavy reliance on impact consultants, who supplement rather than replace the core investment team. This model has enabled large financial institutions to quickly answer the demand for impact, by outsourcing the identification and due diligence of bespoke impact investment opportunities that are too small to merit the attention of research departments. It remains to be seen how this model will hold-up in a down market when investors and institutions face shrinking budgets. It will depend in part on how the strategies recommended by these consultants fare, and on how large institutions choose to proceed with values-aligned investing.
In the aftermath of a financial crisis and the ensuing social instability, we can expect an increase both in the demand for values-aligned investing, and the pressure on financial institutions to offer such strategies. This could mean more greenwashing. Already, nearly every pitch deck I see for a new fund has the words ESG or impact in it somewhere, even if it’s for mining coal using child labor.
A better scenario would see large institutions doubling down on deep ESG integration and impact by building out their own teams, and bringing existing expertise and consultants in-house. However, expanding capabilities is difficult to do down markets, as increases in headcount and overheard are frowned upon by investors and analysts. A forward looking institution would look at increasing their capacity now, in advance of the coming recession the growth in wealth held by millennials.
The pressures that the next recession will apply to the values-aligned investing industry are not trivial. A shakedown of some of products and players in the space is inevitable and even desired, though a larger failure due to lackluster performance would reflect poorly on the industry as a whole. It is incumbent upon us, those who care deeply about this industry, to ensure that the products and strategies we recommend are grounded in rigorous financial analysis that will prevent such failures and the resulting setback to the values-aligned investment industry.
Avi Deutsch is principal at Vodia Capital.