After the first calendar year of outflows from US sustainable funds in 2023, the time has come for investors to consider rational sustainability as a middle ground between abandoning and continuing with ESG investing
ESG investing—considering environment, social, and governance issues as part of financial analysis—has been battered since Russia’s invasion of Ukraine in early 2022. US sustainable funds weathered their first calendar year of outflows since Morningstar began tracking this data more than 10 years ago as investors withdrew $13bn from US sustainable funds in 2023, and US sustainable fund closures outpaced sustainable fund launches during the second half of 2023. Political backlash against ESG in the US, the relabeling of ESG products, and the underperformance of ESG funds since 2022 have contributed to these outflows. Lawmakers in New Hampshire even introduced a bill last week that seeks to make using ESG criteria in state funds a felony.
At the same time, ESG has begun a quiet rebranding. For example, last June, BlackRock CEO Larry Fink publicly abandoned the term “ESG” but noted that BlackRock has not changed its stance on ESG issues. In addition, earlier this month, the World Economic Forum published a report on its Stakeholder Metrics Initiative, which 158 companies have already started using to report on people, planet, prosperity, and principles of governance in their mainstream reporting materials since their launch in 2021.
Rather than gravitating between the extremes of abandoning ESG integration and simply rebranding without addressing legitimate concerns with ESG, institutional investors would benefit from reviewing the middle ground of Rational Sustainability that London Business School Professor Alex Edmans calls for in his new research.
What Is Rational Sustainability?
Core
, outcome-focused, and transparent. Rational sustainability focuses on creating long-term value for intrinsic reasons regardless of whether the drivers of long-term value creation—such as productivity, innovation, and culture—fall under the ESG label. Rational sustainability welcomes sustainability analysis as part of core investment decision-making, and the bland terminology avoids politicization. It pursues any societal objectives in a sustainable way and is explicit about any non-financial objectives and any financial returns it is willing to sacrifice for these non-financial objectives.
Evidence-based and rational. Rational sustainability involves a careful approach to analysis and logic: it focuses on the dimensions of sustainability that are linked to financial performance and probes the complexities of measuring dimensions of sustainability that have no or negative correlation with returns. For example, the highest quality academic evidence—including the work of Professor Katherine Klein of Wharton and Professor Jesse Fried of Harvard—finds zero or negative link between diversity and company performance, but a holistic measure that incorporates equity and inclusion is positively linked to performance. Rational sustainability avoids herd mentality, allowing investors to sell overpriced sustainable companies and buy underpriced sustainable companies that do not tick ESG boxes.
Focused. Rational sustainability recognizes that increasing sustainability beyond a point can mean diminishing returns, increasing costs, and tradeoffs between social and environmental issues. Rational sustainability sharpens corporate focus to sustainability activities for which it has unique expertise and prioritizes the stakeholders that are most important for the business model.
Toward a Rational and Sustainable Investment Portfolio
Environmental, social, and governance issues remain important to investors, corporate board and executive suites, regulators, employees, and customers. Focusing on outcomes, careful analysis, and recognizing tradeoffs are also critical to incorporating sustainability into the investment process in a way that maximizes long-term value creation for the stakeholders that are most important to the business model.