Sustainability has undeniably been the buzzword of 2019. This guest piece from the strategy team at Liquidnet examines the appetite for ESG and where the challenges lie. The author notes that in Europe alone, last year, 300 ESG funds were launched that showed evidence of greenwashing. We hope readers in all regions find this insightful.

Environmental, Social, and Governance (ESG) has been an important investment trend in 2019. Many European asset managers have either already set up an ESG fund or are looking at adding an ESG overlay across existing funds and asset classes to satisfy client demand. New disclosure legislation being ironed out by the European Commission should further speed up ESG factors making it into the investment process. Considering such momentum, Rebecca Healey, global head of market structure and strategy at Liquidnet looks at the coming opportunities and challenges, not least in liquidity. The usual editorial disclaimers apply. Email comments to tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

As ESG and sustainable investments become mainstream, liquidity will be a key area of focus. It is important to remember that performance is only delivered once the investment strategy has been executed. A shift towards ESG may make certain sectors and assets less popular. Some which were once deemed liquid and easy to trade are already becoming less liquid as specific stocks fall out of favor with investors. For example, energy stocks once made up 13 per cent of the S&P 500; they now represent just 4 per cent, a decline of 63 per cent in little more than a decade. Current trading strategies need to adjust and evolve as a result.

Rather than focus on the exclusion of the so-called “sin stocks”, asset managers are incorporating an increasingly broad set of criteria into investment strategies based on one or more of the 17 UN Social Developmental Goals (SDG). SDG is a critical framework providing measurable outcomes - either as a starting point or as a sanity check for a particular investment strategy. Not all of the 17 SDGs, nor the 169 underlying indicators, can be viewed in the same light, but all can provide a useful best-case scenario. This raises some interesting questions such as should a fund invest in US Treasury bonds for example if they object to certain US policies that have human rights implications.

Fixed income...
Looking specifically at the fixed income market, cumulative issuance in green bonds is reported to have reached the $1 trillion mark,  driven by corporations and governments looking to raise funds to meet carbon emission commitments in accordance with the Paris Agreement on climate change. The growing demand for green assets has resulted in an increasing liquidity challenge in secondary market trading: many green bond buyers hold to maturity which means they must often pay a scarcity premium ranging from 1-5bps vs. non-green bonds.

This is in tandem with a wider liquidity squeeze where a quarter of the $15 trillion fixed income market is trading on negative yields and the average liquidity shortfall across bond funds has increased by about a third over the past two years. Concerns among regulators that bond funds may struggle to meet repayments have been exacerbated by recent high-profile institutional fund challenges and are leading to changing trading behaviors and an increasing electronification of the market.

Value of data...
Incorporating ESG factors not only extrapolates the amount of data required to form an initial investment decision but also to monitor and track the suitability of a particular holding within a portfolio. New alternative data providers offer different services which provide an additional overlay, but ultimately company engagement, along with proprietary qualitative and quantitative analysis, will continue to provide the edge, differentiating those who have expertise in this investment strategy versus those looking to follow in others’ footsteps. Technology solutions will be key in order to enable PMs to read through the growing volume of data and extract valuable information.

Regulation toughening...
Factoring ESG into the investment process is also reshaping research consumption. Last year, in Europe alone, 300 ESG funds were launched which showed evidence of greenwashing, according to Morningstar. As such, investment firms are under increasing pressure to demonstrate how they are adhering to sustainable investing principles, how research is accessed, what data is used and how this is incorporated into the investment process.

ESG can no longer be considered an investment fad. It is the means by which asset managers are holding companies to account, scrutinising their P&L to a far greater extent to understand how firms are making money and whether that business model is sustainable in a future carbon neutral world. New regulatory focus on disclosures will accentuate the challenges of ensuring that asset managers make the right investments.

To ensure successful execution of these investments, buy-side traders will need to focus on incorporating new data sources and analytics as the squeeze on liquidity becomes exacerbated in the move to a more sustainable capital markets eco structure.