This Industry Veteran Thinks ESG Funds Are Falling Short. So He’s Turning to AI and Carbon Permits to Fix Them.

Sustainable investments need to be actively managed — and their positive outcomes provable — to avoid the risk of greenwashing.

Bardek Sadowski/Bloomberg

Bardek Sadowski/Bloomberg

John Pileggi, whose 35-year asset management career includes running a bank’s mutual fund and distribution business, believed ESG investments were hobbled by two problems he thought he could fix: the challenges that active managers face when trying to deliver consistent alpha, and the need to assure investors that the funds are actually doing what they promise and aren’t simply engaged in greenwashing. Greenwashing isn’t just a theoretical problem. It’s an issue that has put asset managers in the cross hairs of regulators, who are increasingly on alert for it. In fact, Securities and Exchange Commission Chairman Gary Gensler has raised the possibility of requiring clearer labels for sustainable funds.

Shortly after meeting the co-founders of Turing Technology Associates, which supports an approach called Ensemble Active Management, Pileggi thought he had the solution to the first problem, alpha. EAM uses data science techniques known as ensemble methods, which have been used successfully in almost every industry except investing. According to several papers, including one published in 2019 in CFA Institute’s Enterprising Investor, these help preserve active managers’ alpha with a new approach to diversification. Using ensemble methods, which rely on artificial intelligence and machine learning, firms can use the highest-conviction stock picks of multiple managers, rather than the solo managers employed by most active funds, to provide downside protection. Put in context, it makes sense. Alexey Panchekha, a PhD in math and physics and one of the co-founders of Turing, said, “Concentrated portfolios have a statistically better chance of outperforming. Your best thought is valuable, but your fiftieth — not as much.”

Although there are active funds now using the ensemble methods, nothing is available on the ESG front.

“Many of the greatest managers out there tend to water down their ability to create alpha. EAM’s science strips away many of the issues and leverages the wisdom of experts,” said Pileggi, who has been the CEO of Strategic Innovations Advisors since 2017. He witnessed the failings of active management decades ago at the bank (ING Bank, which was acquired by a rival after the global financial crisis) and of other wealth managers and advisors over the years.

When Pileggi met Panchekha and Vadim Fishman, the CEO of Turing, he thought that the ability to tap the expertise of multiple managers would be particularly groundbreaking in ESG, where picking stocks based on values was a relatively new field and required certain expertise, and where many investors were still waiting to see that the funds could generate good returns as well as good outcomes, such as decreasing corporate carbon footprints.

Then Pileggi came across Climate Vault, a nonprofit that builds net zero solutions. Climate Vault seemed to offer an elegant and systematic solution to the greenwashing problem. “They make no value judgments about a company’s ethos or values. They simply say that if you have a portfolio, and the characteristics of the portfolio are to your liking, we have the wisdom of experts to help you conclude what your dollar-for-dollar carbon footprint is. We can correct the problem,” he said.

Here’s how it works: Pileggi’s company provides information about the portfolio generated by Turing, and Climate Vault then quotes a price to decarbonize it. Financed by management fees, rather than by deducting the cost from the portfolio where investors would pay, Pileggi’s firm makes an irrevocable donation to Climate Vault.

Essentially, the decarbonizing component is structured as an overlay to the portfolio; the overlay is run monthly. Through the partnership with Climate Vault, SIA measures the carbon footprint of every company in the portfolio. Carbon permits are then purchased from cap-and-trade compliance markets and locked in a virtual vault so the emitters can’t use them. With the number of permits capped, the solution permanently decreases the amount of carbon dioxide in the atmosphere.

The only way Climate Vault will put those permits back into circulation is if the proceeds can be used to further the development of impact technologies for companies that can’t access the capital markets.

The design structure reduces — on a dollar-for-dollar basis — the carbon emissions linked to the stocks held by the NetZero portfolio. Although many ESG funds may ultimately invest in companies that will make a difference in reducing greenhouse gas emissions or develop innovative solutions to climate problems, Pileggi’s fund could immediately document its positive outcomes.

“Investors get the benefits of EAM and all that comes with it. Secondarily, they get to decarbonize the portfolio I’m creating,” Pileggi said. SIA currently is running what it calls the NetZero investment solution, a strategy for clients. The firm has a number of future plans, including an exchange-traded fund version of the strategy.

Pileggi is creating a fund that will provide environmental benefits that can be proved and documented. But that’s where his goodwill ends. He’s not sharing it with other asset managers, having recently filed a patent on the concept and design.