November 11, 2019

Monday Morning Memo: ESG Can Be a Reputational Risk for the Investment Industry

by Detlef Glow.

Sustainable investments based on environmental, social and governance (ESG) criteria are the hottest topic in the European investment industry. But as there is no single definition of what “an ESG investment” means exactly, there are many different approaches in the market. The wide range of criteria to select securities that are sustainable from the investment manager’s point of view is confusing for investors and investment advisors. Therefore, there is a lot of responsibility on the shoulders of investment advisors and fund platforms when it comes to fund selection capabilities because investors trust their fund providers to label ESG investments accurately. This means there is a huge reputational risk for the respective investment advisor or fund platform. As a result of this, it is not surprising that a high number of investment advisors and investment platforms seek help from third-party providers to enable their customers to search for the funds that best fit their needs and/or values. This way, they can avoid the reputational risk coming from misleading advice.

But is it really enough to transfer the responsibility for the fund selection over to a third party to avoid reputational risk? I don’t think so, since an error of the service provider will in a number of cases fall back on the provider who used the respective screening tool. To avoid this kind of reputational risk, the respective provider must do its homework and needs at least to review the list of funds for obvious errors or misleading recommendations.

This gets even more important when the respective fund platform belongs to an asset manager that should know which of its own funds comply with the respective selection criteria and which do not. Otherwise, investors can claim that they were tricked into a fund that they wouldn’t have bought otherwise and might seek legal redress.

That said, all investors and market observers should be aware that even the best fund screening models can be misleading if the underlying information—such as the description of the investment strategy of a fund—is wrong or misleading, or if there is a lack of transparency with regard to the disclosure of the holdings in a portfolio. The fund industry should review its current standards with regard to the marketing of funds and the use of key words such as environmental, social or governance, etc. in the legal and/or marketing documents. It might be a worthwhile endeavor if market regulators started a probe identifying mutual funds that are using these kinds of key phrases, especially in legal but also in marketing documents, without implementing the respective criteria within their investment process. This should be seen as fraud and penalized as such.

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

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