Toward ESG 2.0: How to Design a Truly Progressive Fund

March 18, 2016

Kristi Mitchem

Regardless of your political stripe, it would be hard to argue that, culturally, this is a new era of progressivism. Over the past 20 years, the concept of corporate social responsibility has gone from a glossy report short on substance to a key factor in the creation of sustainable enterprises. The message of the triple bottom line promoted by corporate responsibility expert John Elkington has moved beyond the vision of free-spirited, purpose-driven founder-CEOs — such as Blake Mycoskie of TOMS Shoes and Ben Cohen and Jerry Greenfield of Ben & Jerry’s — to best practices discussed in staid boardrooms. The battle over so-called political correctness has ended, and social justice has triumphed. Today consumers and investors want, as the Economist aptly described in 2012, “to make society fairer without reducing its entrepreneurial vim.” And they are also seeking a return on equality, not just a return on equity.

As recently as a decade ago, an investor could seek social change through negative selection of her capital allocation — she sought to make an impact by consciously avoiding investments in companies with policies and practices that were not aligned with her own. The limits of negative selection ought to be immediately clear. First, avoidance isn’t engagement, and engagement is the most effective means for effecting change. The individual investor — despite her principled stand — was not an effective change agent on her own. She was not going to be capable of persuading a corporation to change its behavior or policies because she’d given up her strongest way to engage: her voice. Second, whereas negative selection had the ability to reward her conscience, there was no guarantee that it would do the same for her wallet. Doing good didn’t always equate with doing well for the individual investor — or publicly traded companies, for that matter.

To bridge this gap, a new class of investments, the so-called ethical investment fund, began to emerge. Such a fund might typically feature allocations in small, socially conscious companies, with the bulk generally considered ethically neutral at best. The mantra of “first, do no harm” might work for doctors, but given the modest assets under management, it doesn’t work for social change.

The limitations of negative selection and ethical investment funds — from both a change and return perspective — demand that the industry create a new class of ESG (environmental, social and governance) investment vehicles. Change isn’t the result of thrusting inequalities into the spotlight. It’s an outcome of accountability. If the asset management industry truly hopes to create a product that delivers on the promise of ethical investing, it must focus less on optics and more on actual outcomes. The next wave of ESG vehicles must be designed so that they not only create returns and social equality, but the funds themselves must also be structured so they are aligned with the values they support.

If the asset management industry hopes to create a truly next-gen version of the ESG fund, it will have to do more than identify and provide permanent capital to companies that support social equality and environmental sustainability. These funds must make accountability a central element of their investment criteria. With their capital serving as a bully pulpit, these funds should encourage more purposeful policies that create social change and return for shareholders. These funds must exemplify the spirit and the letter of the policies they seek to advance. From their structure to their management to their allocation of a portion of the returns they generate, ESG 2.0 funds must embody the change they seek to create.

It’s time for our industry to meet the demands of today’s progressive investor. Her investment dollars should give her not just a voice in shaping the direction of a company, sector or industry; it should give her a voice in shaping the future and creating a more diverse, more equal and more sustainable world. The ESG funds in which she invests should make a path for other progressive financial products that improve access to markets for all investors. The asset management industry’s next ESG product should show today’s investor that change isn’t just possible. It can be profitable too.

Kristi Mitchem is executive vice president and head of the Americas institutional client group at State Street Global Advisors in Boston.

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