Driven by demographics and investors’ desires to get ahead of both the effects of social change and an expected wave of regulation, we are seeing a boom in sustainable and socially conscious investments, popularly known by the shorthand acronym ESG (Environmental, Social, and Governance). This kind of socially responsible investing, also known as sustainable, green, or ethical investing, can apply to any investment strategy which seeks to consider social and environmental change regarded as positive by proponents, in addition to financial return.
While ESG could be dismissed as a trendy fad, the numbers indicate otherwise. In 2020, investment in ESG-oriented funds numbered in the trillions of dollars, according to data from Morningstar. Far from a fad, ESG looks to be an important consideration for the future, growing in significance for both institutional and retail investors.
The total U.S.-domiciled assets under management using sustainable investing strategies, both retail and institutional, grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the start of 2020, an increase of 42%. The Forum for Sustainable and Responsible Investments estimates that the amount of professional money managed using all three ESG criteria now represents 33%, or one in three dollars of the $51.4 trillion in total U.S. assets under professional management. In asset-weighted terms, climate change is the most important specific ESG issue cited by money managers who invest both institutional and individuals’ money, with $4.2 trillion devoted to this issue, a rise of 39% from 2018.
What Is It?
As noted, ESG refers to three central factors—environmental, social, and governance—in measuring the sustainability and societal impact of an investment in a company or business. ESG grew out of earlier investment philosophies of socially responsible investing, but there are key differences.
The earlier models typically used value judgments and negative screening to decide which companies to invest in, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement with the South African regime supporting apartheid.
ESG investing and analysis, on the other hand, looks beyond supporting a set of social values to finding financial value in companies as well. Ethical considerations and alignment with social values remain common motivations for many ESG investors, but as the field is rapidly growing and evolving, many are looking to incorporate traditional financial analysis into the ESG investment process.
The number of large, publicly traded companies across the globe that have said they are adopting ESG criteria and the number of fund managers who say they are using ESG screens to identify investments also has been growing.
ESG metrics are not commonly part of mandatory financial reporting, although companies are increasingly making disclosures in their annual report or in a standalone sustainability report. Numerous institutions, such as the San Francisco-based Sustainable Accounting Standards Board, the Amsterdam-based independent Global Reporting Initiative, and the London-based nonprofit CDP (formerly known as the Carbon Disclosure Project) are working to form standards and define materiality to facilitate incorporation of ESG factors into the investment process.
How Does It Work?
ESG attempts to frame a company’s performance against a rubric of nonfinancial risks, which cannot be measured as a line item in a firm’s accounting statement, but could still harm it economically if incidents around these risks arise. ESG investors, or anyone who employs ESG criteria, put such risks in buckets represented by the three factors. ESG factors are often interlinked, and it can be challenging to classify an ESG issue as only an environmental, social, or governance issue, but the rough contours are as such:
The environmental factor tracks a range of conservation issues including a company’s carbon footprint or how a business has adapted to climate change. This factor also takes into consideration approaches to air and water pollution, biodiversity, deforestation, energy efficiency, waste management, and water scarcity.
The social factor can include product-safety problems and labor abuses in supply chains, as well as customer satisfaction, data protection and privacy, approaches to gender and diversity, employee engagement, community relations, human rights, and labor standards.
The governance factor assesses the quality of a company’s management and whether the board maintains sufficient oversight. Investors pay attention is paid to bribery and corruption, board composition, audit committee structure, executive compensation, governmental lobbying, political contributions, and rules for handling whistleblower complaints.
ESG critics worry that incorporating these factors into the investment process will hurt performance, while proponents counter that studies show good investment returns will follow from pursuing the public good. Major asset managers note that monitoring ESG factors can offer a valuable window into matters not reflected in a company’s financial statements.
A recent study by the BlackRock Investment Institute, for example, found that ESG-focused equity indexes at MSCI matched or beat the annual returns of traditional benchmarks over a period between 2012 and 2018.
Other studies suggest that companies with robust ESG practices displayed a lower cost of capital, lower volatility, and fewer instances of bribery, corruption, and fraud over certain time periods. The studies have shown that companies that performed poorly on ESG have had a higher cost of capital; higher volatility due to controversies and other incidences such as spills, labor strikes, and fraud; and accounting and other governance irregularities.
Perhaps unsurprisingly, numerous academic and investor studies in recent years have found historically lower risk and even long-term outperformance for portfolios that integrated key ESG factors alongside rigorous financial analysis. The outperformance was particularly noticeable in emerging markets, where corporate disclosure on ESG risks lag behind that of the U.S. and Europe.
Here to Stay
The strength of sustainable investing suggests that ESG has staying power. Funds focused on socially responsible investing have been a rare bright spot in the recent market meltdown, indicating that ESG is more than a bull-market trend. Some skeptics have said that investors might be willing to put their money into financial products that reduce their exposure to, say, fossil fuels when stocks charged higher, but predicted investors would abandon the socially responsible practices for higher returns in times of turbulence. However, recent market trends have contradicted this skepticism.
“This crisis has shown that ESG investing is here to stay—ESG is not a fad,” says George Serafeim, a Harvard Business School professor who has studied sustainable investing. “People are looking for resilience. They are looking for companies that are able to weather the short-term storm and are positioning the business for long-term success.” According to a study published last month by Serafeim and researchers from State Street Associates, companies that protected their labor forces and supply chains during 2020’s stock-market drawdown saw more net inflows from institutional investors and better returns than their industry peers.
Funds available to U.S. investors that use ESG principles captured $51.1 billion of net new money from investors in 2020—the fifth consecutive annual record, according to Morningstar. In 2019, investors funneled roughly $21 billion into funds that apply ESG principles. Also, investors poured $20.5 billion into sustainable funds during the final three months of 2020, setting a quarterly record, doubling the previous record for a quarter. Flows into ESG funds represented 24% of overall flows into U.S. stock and bond funds for the year.
The number of ESG funds available to U.S. investors grew to almost 400 last year—up 30% from 2019 and a nearly fourfold increase over a decade, according to Morningstar.
This growth comes as investors—primarily younger cohorts—have been animated by systemic issues like climate change and wealth inequality. According to a recent survey conducted by Morgan Stanley’s Institute for Sustainable Investing, nearly 95% of millennials are interested in sustainable investing, while 75% believe that their investment decisions could impact climate change policy. COVID-19 has also acted as a turning point. Not only has the global pandemic underlined the importance of resilient business models, but it has shown that how companies treat all their stakeholders—including employees and customers—can impact the bottom line.
Risks and Research
Last year, sustainable funds performed well last year relative to conventional funds during the uncertain economic and market conditions caused by the pandemic, underscoring the value of considering ESG risks in portfolios. A post-pandemic “green” recovery could benefit the stocks of companies that produce more sustainable low-carbon products.
However, one caveat is that there is currently no standard definition for sustainable investing and no uniform way to track a company’s ESG metrics, especially in the U.S., where issues such as diversity and pay practices do not have to be publicly disclosed.
Additionally, there are many different approaches to ESG investing, which means that funds can have very different practices. Some might exclusively invest in clean energy or companies that have a woman on their board of directors, while others might essentially track the S&P 500 but adjust their component weightings based on a company’s ESG score.
With this lack of definition and rules, investors experience increased risks that a fund will not meet their expectations. Thus, researching these funds before jumping into them is imperative.
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