June 2020

Traditionally, investing has focused on the singular notion of maximizing shareholder value or financial profit.  In recent years, many investors have expanded their investment scope in search of creating sustainable value and affecting positive change by incorporating Environmental, Social, and Governance (ESG) factors.  While Sustainable or ESG investing is not a new phenomenon, it has gained significant momentum.  Increasingly, ESG investing is being viewed not merely as a means of driving potential positive impact in the world, but as a more holistic way to evaluate overall corporate performance, manage risk and drive long-term financial return.

Defining Sustainable or ESG Investing

Sustainable investing is the integration of environmental, social, and governance (ESG) factors into investment research processes and decision-making.  ESG factors cover a broad spectrum of issues that traditionally are not part of investment analysis yet may have economic relevance for investors.  In addition to the owners of a company’s stock who may benefit financially, ESG investing seeks to account for the interests of other stakeholders, such as customers, employees, the communities where they operate, and the planet itself.  Morningstar, which uses the terms Sustainable or ESG investing interchangeably, recently described each aspect of ESG in the following way:

“Environmental covers greenhouse-gas emissions, energy use, land use, waste management, water quality, and hazardous materials. 

Social encompasses labor standards, worker safety, equal employment, community impact, and healthcare. 

Governance looks at business ethics, board independence and diversity, shareholder voting rights, executive pay and employee pay, lobbying and political expenditures, and accounting transparency.”

The Different Flavors of ESG Investing

ESG investing has undergone an evolution from a primarily exclusionary approach to more integrated or direct methods.  The ESG methods described below, which are not exhaustive and often used in combination with one another, can be generalized into the following groups:

1. Exclusionary or Values-Based Screening is the oldest form of ESG investing and is commonly referred to as Socially Responsible Investing (SRI).  It refers to avoiding securities of companies, industries, or countries based on traditional moral values (e.g., products or services involving alcohol, tobacco, or gam­bling) and standards (e.g., human rights and environmen­tal protection). 
2. ESG Integration refers to the systematic and explicit inclusion of ESG risks and opportunities in investment analysis.  A “Best-in-class” approach to integration refers to preferring companies with better or improving ESG factors relative to their industry.  An example would be to invest in one technology company over another because it has better data privacy standards.
3. Thematic Investing refers to investing that is based on trends, such as social, industrial, and demographic trends. Several investment themes are clean-tech, green real estate, sustainable forestry, agriculture, education, and health.
4. Impact Investing refers to investing with the disclosed intention to generate and mea­sure social and environmental benefits.  An example of Impact investing would be to invest in a company that delivers clean water to rural villages.

Importantly, many ESG strategies incorporate active ownership, which refers to the practice of asset managers entering a dialogue with companies on ESG issues and exercising both ownership rights and voice to effect change. 

Advancements and Issues with ESG Data Standards & Monitoring

A major challenge for ESG investors is procuring relevant data on environmental, social, and governance issues, and then applying it in a financially meaningful way.  As it relates to financial reporting, investors have become well-accustomed to accounting standards established by FASB, the Financial Accounting Standards Board.  Fortunately, similar standards are being built for ESG reporting, principally led by the Sustainability Accounting Standards Board (SASB).  Importantly, SASB has focused on codifying ESG data standards that emphasize Materiality, the idea that not every ESG issue is relevant to every company. 

While data availability and collection have both come a long way in recent years, investors must always be on alert for concepts like corporate “Greenwashing” or creating a false impression that the company’s culture, policies, products and/or services are ESG friendly.  In general, however, positive strides have been made in setting uniform standards while making relevant data available to those interested in incorporating ESG factors into their investment research processes.

Performance

While traditional investing measures performance against a market index like the S&P 500, ESG investing aims to see progress in the factors they are investing in, while also generating a competitive return.  As a result, ESG investors should generally expect that investment performance can be materially different than traditional market indices, given their different portfolio construction methodologies.  Investors might also expect that the fees associated with ESG investing may potentially be higher, given the added research and monitoring considerations involved.  The question is whether the net of fee performance might be better or worse?  Given the diverse nature of ESG strategies and the relatively short-track record of many funds, there is no clear consensus answer.  Historically, when ESG strategies primarily excluded entire market sectors (SRI), a performance penalty could be reasonably assumed and was many times realized.  The ascendance of ESG Integration or “best-in-class” strategies seems to have altered that dynamic. 

According to Morningstar, over the last three years ending in 2019, sustainable funds have performed well overall within their broad-based categories, which include non-ESG funds.  For example, over the previous three years, 40% of sustainable funds placed in the top quartile (25%) of their categories and approximately 67% in the top half.  Similarly, positive results occurred over the last 5-years.  

So, while no clear conclusion can be made about the long-term relative performance of ESG versus non-ESG funds, recent data has been quite supportive, throwing some cold water on the idea of a performance penalty for ESG investors.

ESG is Here to Stay

Cynics may argue that ESG investing is just a fad, but a closer look at the actions of investors and corporations suggests otherwise.  In a letter to their clients to start 2020, the world’s largest asset manager, Blackrock, recently announced several initiatives to place sustainability at the center of their investment approach.  Simultaneously, Blackrock put CEOs of corporations on notice that they will wield their proxy voting power “against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”  State Street, the world’s third-largest asset manager, contacted corporate boards to deliver a message, “ESG is no longer an option for long-term strategy.”  Companies like Starbucks and Microsoft, among many others, have responded with ESG-friendly initiatives. 

In a final potential tipping point, shareholders are increasingly deploying their dollars into strategies that promote a shift toward long-term and sustainable stakeholder value.  Per Morningstar, in 2019, over $21 billion of funds moved into U.S. ESG Funds, nearly a four-fold increase from 2018, which held the previous record.  The momentum has continued in 2020, as an additional $10 billion moved into U.S. ESG funds through March.

Increasingly, there seems to be a recognition that the concepts of doing well for shareholders and doing good for stakeholders are positively aligned and not mutually exclusive.  We believe that ESG is here to stay and that it is a positive development for investors and society.

 

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