Does categorising funds as ‘ESG integrated’ make sense?

As just one component of an investment strategy it's difficult to justify integration as a category

If you’re looking for an investment fund, it won’t be long before you encounter one that is categorised as an “ESG integration” fund. The mere existence of the category implies that ESG integration funds are different from other sorts of funds. But how exactly are they different, and do the differences warrant a distinct product category? Before tackling this question, we need to lay some groundwork.

First, we need to establish what ESG integration is. Too often, the term is misused to refer to the inclusion of ESG factors in any way and for any purpose. ESG integration, however, is a technical term that means something quite specific: the consideration of material ESG factors within the analysis and decision-making components of an investment process with the aim to improve risk-adjusted return. ESG integration is not screening, nor is it a target allocation to certain kinds of investments or an aim to achieve real-world objectives.

Next, we need to understand the role ESG integration plays in a fund. Investment professionals understand ESG integration as a set of tools that help them identify and evaluate drivers of risk and value that are related to natural resources, human capital and corporate governance. These drivers are certainly not the only drivers of risk and value, and therefore, ESG integration is not a standalone investment strategy. Rather, it can be one part of an overarching investment strategy.

Finally, we need to think about a fund as an integrated system of objectives, constraints, policies, and processes. In this way, investment funds are like other complex products such as cars or computers. Because ESG integration is a component of the investment process, we can think of it as being a feature of an investment product.

Categorical distinctions

Now using these insights, let’s expand the question and ask if and when it makes sense to use a specific feature as a differentiator for product categorisation. Why, for example, do people often make a categorical distinction between cars and trucks, coupes and sedans, gasoline and electric vehicles, two-wheel drive and all-wheel drive vehicles, but not a categorical distinction between vehicles with and without sunroofs, cruise control, airbags, navigation systems or heated seats?

Categorical distinctions are often made on the basis of the significance and extent of differences in form, function, performance, use, or some combination thereof. There are, for example, extensive and significant differences between cars and trucks, and this is why cars and trucks are categorically different.

It is possible for a single feature to drive product categorisation, but typically, the feature must be critical to the functioning of the product (e.g., the transmission of power to all four wheels) and have differentiating power (e.g., not all vehicles have four-wheel drive).

In the investment industry, it’s sensible to make categorical distinctions, for example, between stock and bond funds because equity and debt are different financial instruments with different legal structures.

It’s also sensible to distinguish between an equity fund that aims to achieve returns primary through capital appreciation versus dividends because the nature and timing of the returns can have important implications for investors.

Given that ESG integration is but one component of an overall investment strategy and given that a large percentage of funds employ ESG integration, it is difficult to justify a categorical distinction on the basis of extensive and significant differences or on the basis of criticality and differentiating power of ESG integration as a feature.

Integration as a feature

Does this mean that ESG integration is not valuable or important? Not at all. Airbags are valuable and important, but they’re not used as a distinction for vehicle categorisation. Airbags are treated as a feature rather than a categorical distinction, and that is how ESG integration should be treated as well.

The question posed in the title is not simply an academic one. It has implications for the marketplace. Managers categorise their products for presentation to clients. Consultants, advisers and databases categorise products to facilitate product selection. Even regulators have proposed categories to drive different sets of disclosure requirements.

The last time I shopped for a car, dual front and side airbags were on my list of essential features. When I bought my car, I knew I was buying a car with airbags and not an “airbag” car. The lesson that I hope readers will take from this example is to treat ESG integration as an important feature but not elevate it to a categorical distinction in the minds of clients and the investing public.