The ESG "Horseshoe" - Value Judgements and Fiduciary Duties

18 November 2020

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1.The ESG Horseshoe

In modern political discourse there is a theory that the far-left and far-right, rather than being at the opposite ends of a linear political spectrum, in fact closely resemble one another in many key ideological facets. This is graphically represented as a familiar object which gives the theory its name: the “horseshoe theory”.

Figure 1: The political horseshoe theory

Political Horseshoe.png

Source: Wikipedia.

The extremes of political ideology may appear an unusual starting point for a discussion of ESG investing, however the horseshoe may also be used to illustrate the relationship between different approaches to responsible investment. It is easy to think of different approaches as marking various points along a spectrum of sophistication and objectives, with an exclusionary approach – or negative screening - at one end (easy to implement, and passively seeking to “avoid doing bad”) and a thematic approach – or impact investing - at the other (complex to implement and actively seeking to “do good”).

Figure 2: The ESG spectrum

ESG Approach.png

Source: Aspect Capital.

However, much as the theory goes that certain characteristics unite the extreme left- and right-wings of political ideology, so it can be argued that the two seemingly opposing approaches to ESG investing outlined above in fact share some important traits. Most significantly, both approaches imply a subjective or even moral/ethical judgement as to what is “good” and “bad” from an ESG perspective, even if the decision whether to exclude the “bad” or embrace the “good” sets them apart. In addition, neither approach necessarily seeks to account for the impact of ESG factors on the price of the underlying assets: both arguably prioritise said moral/ethical considerations above pure investment returns.

So, what lies at the centre of this ESG “horseshoe”? The answer is an approach which implies the active integration of ESG factors but no moral judgment, and which might be described as “pure ESG integration”. Such an approach would consider ESG factors within the investment decision-making process solely from the perspective of what impact those factors have on the price of the underlying assets, and not on the basis of ethical judgments or intended ESG outcomes. In summary, such an approach to ESG integration could be described as focusing on “value, not values”.

Figure 3: The ESG horseshoe


Source: Aspect Capital.

2.The difficulties of ethical judgments in ESG investing

The appeal of the “pure integration” approach to ESG investing is clear for those investors and managers who are just beginning to crystallise their thinking around this topic, and a consensus is beginning to emerge around such an approach, pushing values-based negative screening and impact investing to the edges as niche approaches within the field of ESG investment. Indeed, the Principles for Responsible Investment define responsible investment as, “…a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions…”[1]: no mention here of moral judgements or positive ESG outcomes.

This tendency towards an ESG integration approach is likely driven by at least three factors:

  1. Lack of consensus on value judgments: Each investor and manager is likely to have a different subjective view on what is “good” and “bad” from an ESG perspective, leaving managers who seek to embed such judgments within their investment approaches open to scrutiny and raising the possibility (or likelihood) that a product incorporating explicit moral or ethical judgments is unlikely to cater for all investors’ requirements.
  2. Lack of manager expertise: Investors may not consider the sorts of moral judgments implied by a values-based approach to ESG investment to be within a manager’s core competencies. Managers are paid to make investment decisions, not ethical ones.
  3. Antagonism between value judgments and fiduciary duties: As noted above, at the extremes of our ESG horseshoe, it is arguable that moral and ethical judgments are prioritised above investment returns. Under current frameworks, this puts investors and managers in a potentially difficult position opposite their fiduciary duties to their beneficiaries and investors, respectively.

This latter point has been brought into sharper focus by recent proclamations and proposed rulemaking on the subject from the US Department of Labor, which made it abundantly clear that plan trustees’ fiduciary obligations do not extend beyond pure pecuniary outcomes to any wider societal benefits: “Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan”[2]. While the final rulemaking has been watered down somewhat[3], it’s clear that this sub-set of the investor community, ESG factors may only be incorporated into the investment decision-making process to the extent that they can be conclusively demonstrated to benefit investment performance; and this is a question that the entire investment community will need to confront in developing their own ESG strategies.




3. Shortcomings of a "pure" ESG integration approach

The pure ESG integration approach is not without its own shortcomings, however. Despite the earlier comments, there is no doubt that for many investors the current focus on ESG investing does have at its heart a moral/ethical angle, and to ignore this altogether may be considered somewhat tone deaf in the current environment. Indeed, while the PRI’s definition of responsible investment doesn’t reference a values-based approach, positive overall ESG outcomes are at the very heart of its mission, which upcoming changes to its reporting framework from 2021 will further emphasise - with a greater focus on sustainability outcomes.

An approach to ESG investing which ignores value judgments entirely and applies ESG integration in its purest form could even result in perverse outcomes. Imagine, for example, that based on its analysis, a manager concluded that positive ESG factors are in fact detrimental to the price of a particular asset class over the long-term, while negative ESG factors have a positive impact on those asset prices. Adopting a pure ESG integration approach – taking account only of the impact of ESG factors on asset prices and with no value judgment accounted for – would lead to the manager going long those assets with “bad” ESG characteristics and short those with “good” ESG characteristics. Such a manager could claim to be adopting an ESG-based approach to investment, but logically would be unlikely to attract investment from allocators seeking to implement their own ESG-based guidelines – even if they could demonstrate superior investment returns.

Consequently, it may not be desirable for any investor or manager seeking to demonstrate their responsible investment credentials to exclude moral or ethical considerations completely from their approach.

4. The optimal point on the horseshoe

For the majority of the investment community, therefore, it is likely to be a question of identifying and adopting a strategy which appropriately balances the values-based and pure integration approaches.

At Aspect, the values-based approach is aligned with our overall outlook as a firm, and we have a desire to meaningfully integrate ESG factors into our investment approach where possible. But this is counter-balanced by our view that the primary responsibility we have to our investors is to generate returns commensurate with our investment programmes’ stated objectives. This allows for a limited degree of value judgment when it comes to our approach to ESG, but not to the extent it impacts negatively on the return profile of a given strategy.

This is illustrated by the approach we have taken within our systematic equity portfolios. The primary focus when it comes to ESG is on integration: our research shows that positive ESG characteristics provide useful information on future outperformance of an asset, and we have built systematic models which use ESG data on individual companies to exploit that effect. This is then overlaid with an overall portfolio-level tilt towards “good” ESG assets, through a constraint ensuring that the overall portfolio has a positive ESG rating. This marks a slight move along the ESG horseshoe away from the pure ESG integration approach and towards impact investing – but crucially not to the extent that this negatively impacts overall expected returns.

(As illustrated below, a comparable approach which represents a move along the horseshoe in the other direction, towards negative screening, might involve permitting the taking of short positions in “negative” ESG assets but prohibiting the taking of long positions in the same assets.)

Figure 4: Optimising the ESG Approach


Source: Aspect Capital.

Meanwhile, within our CTA/managed futures strategies, we face a number of challenges both with the values-based approach and the pure ESG integration approach. On the one hand, given the overriding focus on diversification, any move along the horseshoe towards a values-based, negative screening approach is likely to have an unpalatable impact on the programmes’ return profiles; while on the other, a lack of data and of ESG-based futures contracts enabling our models to express their views on the ESG risks associated with a given asset class conspire to restrict the scope for adopting an integration-based approach in these strategies.

Ultimately, for us and many other financial market participants currently navigating the ESG maze, it is a case of locating the “optimal point” on the ESG horseshoe – taking appropriate account of moral and ethical factors whilst simultaneously endeavouring to provide diversifying returns for our investors’ portfolios. The decision as to where this optimal point lies is likely to be driven by a number of factors, including both the nature of the investment strategy and the asset classes traded, as well as the particular firm’s own values and culture.


Note: Any opinions expressed are subject to change and should not be interpreted as investment advice or a recommendation. Any person making an investment in an Aspect Product must be able to bear the risks involved and should pay particular attention to the risk factors and conflicts of interests sections of each Aspect Product’s offering documents. No assurance can be given that any Aspect Product’s investment objective will be achieved.

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