Macroeconomic & Geopolitical

Saving the World is Hard

February 2022 – 3 min read

ESG investing has a long way to go, but why shouldn’t global financial markets do their part?

The cut-throat endeavor of extracting as much profit as possible from as little investment as possible now faces demands to improve the fate of humanity at the same time. Objections are natural, but the hardest of hard-nosed investors should relish the challenge of including environmental, social, and governance practices in their analysis. Above all, it’s not really that much more complicated than what they already do, and it means they won’t soon be replaced by a computer algorithm.

Maybe just as important, it allows them to tell their children that, amid their challenging bare-knuckle efforts to choose winners over losers, they are doing their part to make the world a better place. Investment managers may not rank with nurses and math teachers in their contributions to the greater good, but it’s still a pretty worthy career if you can help drive global prosperity while encouraging progress on the goals society shares.

Free markets and profit motive have been at the heart of economic progress since long before Adam Smith’s “invisible hand.” But outside of introductory economics textbooks, people apply all kinds of criteria to financial decisions far beyond securing good value or a reasonable return. They avoid the restaurant where they find the bartender’s politics abhorrent—even if the food’s a bargain. They boycott the fashion line that buys from sweatshops—even if the jeans are a steal. What’s so unreasonable about framing investment decisions in much the same way?

What seems like a recent fad is hardly new. Values have been shaping financial decisions since the world’s great religions began condemning usury. America’s Quakers banned investments in the slave trade, and more modern investors developed their own list of exclusions they deem sinful.

But it may be easier to address the legitimate questions about ESG one at a time.

How do you prioritize among the E, the S, and the G? My favorite hypothetical challenge is the racially diverse management team that donates half its profits to orphans from operating lignite coal mines. It’s legitimately hard to know if your investment should support diversity and underprivileged children at the expense of additional carbon emissions. But investment teams make difficult trade-offs all the time between, say, currency risk and uncertain margin improvement. There are very few clear choices in any portfolio, which is precisely the advantage of a portfolio of choices.

Is my S the same as your S? There is a long list of social concerns in the world and very little agreement on which are most pressing. But like Justice Potter Stewart’s famous line about pornography, good investors recognize socially responsible corporate managers when they see them. For now that should be enough.

How do we measure any of this? These are real challenges that the asset management industry has only just begun to tackle. But anyone who has worked through the Lehman Brothers failure will admit that AAA credit ratings didn’t quite measure balance sheet strength as we had hoped. Ratings along E, S, and G dimensions have a long way to go and will always be imperfect. But this is an area active investors should embrace, since passive vehicles can’t possibly make the nuanced judgements that are so crucial.

Should investment reward effort or achievement? This is perhaps most tricky of all, as investors aren’t necessarily sure themselves if a heavy polluter trying to get cleaner is worth encouraging over a competitor that is setting the industry standard. Again, investors will differ on this choice just as they do on the merits of value vs. growth stocks. The important part is that the managers are clear about what they do and why.

Aren’t all these concerns better left to governments? It’s obvious that engaged governments are a necessary part of solving these questions, but they may not be sufficient. Even if they were to legislate precisely the mean preferences of their voters across these issues, investors and markets provide an important policing and enforcement function that regulators and courts cannot.

Don’t investors give up returns when they include ESG considerations? Some ESG investors claim they can actually deliver higher returns, often suggesting that avoiding polluters helps minimize risks of loss. So far, at least, the academic research on the question is far from clear, but nor is it clear that these strategies deliver significantly worse performance over time.

Do ESG investment choices really drive up the cost of capital for “bad” firms? If that’s how it works over time, then the bond returns of “good” ESG firms will be lower. But much more important than the discipline of capital costs is the engagement from shareholders, ratings agencies, and financial journalists who force companies to explain how they are improving their practices. Even when they are prone to exaggerate, they can’t hide bad behavior forever and their efforts to respond to these concerns are what create better business models in time.

Of course, capital discipline and profit motive alone can do a lot to improve the condition of humanity, and naturally there will be no progress on environmental, social, and governance issues without good laws and vigilant regulators. But doesn’t humanity need all the help it can get? At least, isn’t that what our children will ask?

Christopher Smart, PhD, CFA

Chief Global Strategist & Head of the Barings Investment Institute

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Any investment results, portfolio compositions and or examples set forth in this material are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this material No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments. Prospective investors should read the offering documents, if applicable, for the details and specific risk factors of any Fund/Strategy discussed in this material.

Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).

NO OFFER: The material is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This material is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy, and must not be construed as a projection or prediction.

Unless otherwise mentioned, the views contained in this material are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Individual portfolio management teams may hold different views than the views expressed herein and may make different investment decisions for different clients. Parts of this material may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this material is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any service, security, investment or product outlined in this material may not be suitable for a prospective investor or available in their jurisdiction. Copyright in this material is owned by Barings. Information in this material may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.