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Curatia Analysis for Wed, Aug 21

ESG (2 of 2): Foundations

Even as ESG skepticism persists, robust investor demand is encouraging financial firms to foray into the space with vim and vigor.

But while new funds and strategies have become an industry touchstone for ESG investing growth, a steady stream of under-the-radar deals and product launches around indices and data are quietly pouring the foundation on which the future of ESG will be built.

Positive Indicators

ESG has been a bright spot for asset managers seeking to attract inflows and justify higher fees amid passive investing’s rise and festering market unease. US ESG funds attracted $8.4B in net inflows in H1 2019, eclipsing 2018’s annual record of $5.4B in just six months.

Moreover, early returns on ESG funds have been positive — literally. For the twelve months ended June, 34% of European sustainable funds ranked in the top quartile of their category, while 63% landed in the top half, per Morningstar.

New Funds

Those dynamics have encouraged ESG fund proliferation. Since 2012, the number of sustainable mutual funds has grown 80% to 3,955, while AUM has nearly doubled to $1.8T. Funds launching this year have found particular success. BlackRock’s iShares ESG MSCI USA Leaders ETF, for example, raised $851M in its May debut.

While that fund is pegged to an index, the allure of higher fees has prompted even index-fund apostles to launch actively managed ESG funds. Vanguard’s Global ESG Select Stock Fund, for example, launched in May with a mandate to invest in roughly 40 companies whose “long-standing” ESG practices “can materially impact shareholder returns.”

ESG enthusiasm is even extending to the opaque world of hedge funds, where the proportion of assets tied to ESG criteria is expected to rise substantially from 42% in 2018 to 58% this year, according to a BarclayHedge survey.

In the private equity sphere, Apollo revealed its intention to set up a $1B impact investing fund last week, joining KKR ($1B) and TPG ($2B).

Data & Infrastructure

The breadth and depth of those initiatives speaks to the traction ESG investing is gaining despite lingering pockets of industry skepticism.

The tilt toward active ESG investing strategies also illustrates a decided dearth of data, indices, and other infrastructure foundational to building cost-effective general and specialized offerings in the nascent ESG space.

The construction of such infrastructure is also ramping up, however. In April, Moody’s acquired a majority stake in ESG research and data firm Vigeo Eiris — part of a push to expand its risk assessment services beyond credit into areas like ESG and cybersecurity.

State Street shored up its ESG data and analytics offering in May, exposing data from IdealRatings, MSCI ESG Research, Trucost ESG Analysis, and Sustainalytics to enable clients to calculate ESG scores through a combination of human and machine-generated data.

In the fixed-income space, Bloomberg and MSCI partnered in April to provide a set of ESG fixed-income indices for Canadian markets. In June, the LSE bought ESG fixed-income data provider Beyond Ratings to complement FTSE Russell’s existing ESG index and data offering.

Collectively, those projects provide the building blocks for a robust ESG ecosystem. They not only spotlight ESG’s development but also suggest a broader pattern for the evolution of modern markets — namely, that active fund managers pioneer stock picking in a new field until enough data is available to allow for the creation of indices, paving the way for index funds.

That little-discussed process frames active stock-picking as a manual forerunner of automated passive investing — a theory that better explains active funds’ ongoing struggles than the idea that active stockpicking gets more difficult when low interest rates cause stocks to move together.

If that theory is true, active fund managers may want to think about betting on passive asset managers investing heavily in ESG — a paradox for the ages.