- What exactly is ESG investing and why does it matter now?
- Socially responsible investing is not a new idea, but its landscape has completely changed and is drawing greater attention.
- Sustainability is becoming an increasingly critical factor in investment portfolio construction.
Socially responsible investing has been around since the mid-1700s, when the Quakers prohibited members from participating in the slave trade. However, it only began to come into its own during the political turmoil of the 1960s. Similar to the conversations we continue to have today, socially concerned investors were looking to address issues such as civil rights, labor issues, and women’s rights. And by the 1980s, the leading presidential candidates each advocated for some type of social orientation for pension investments.
It may not be widely known that socially responsible investing held a critical role in ending apartheid in South Africa. It was the Sullivan Principles (penned by Leon Sullivan, a General Motors board member) that created a code of conduct for practicing business in South Africa. Growing concern from a variety of groups in the US, including large pension investors prompted divestment from companies operating in South Africa. For nearly two decades, these large institutional investors avoided investment in South Africa under apartheid, and the ensuing outflows eventually forced 75% of South African employers to band together and draft a charter calling for an end to apartheid.
By the time I was managing socially responsible portfolios in the 1990s, investor focus was on other issues such as tobacco stocks and other “sin stocks.” At that time, such strategies were not particularly sophisticated, as they simply utilized a negative screen to remove all the tobacco stocks, or other offending industries, from the client portfolio. In a time when such stocks were performing strongly, performance was well below the standard benchmark, but that wasn’t the point. These clients wanted their investments to reflect their values and mission, and performance was, in fact, a secondary consideration. However, it became a fairly well-established view that you could not do good and do well (performance wise) at the same time. This view still lingers and, in part, likely explains the relatively low absolute allocation -- though this is changing -- to investments based on environmental, social and governance (ESG) principles and impact strategies. Though these monikers are often used interchangeably, they define different areas of focus and are in different stages of evolution of this genre of investing. We’ll dig deeper into these differences in future posts. For now, the takeaway is that the world of socially responsible investing has completely changed and is drawing even greater attention in an era when so many issues of political, social, and environmental consequence require us to incorporate values in our investing.
So, what exactly is ESG investing and why does it matter now? In a nutshell, it is combining traditional investing methodologies with sustainability criteria to improve long-term investment outcomes. It may come as a surprise, but really shouldn’t if you look at things through a long-term lens; Companies with strong sustainability ratings certainly have a greater likelihood to outperform those with poor ratings. Companies that focus on ESG principles should be in a better overall financial position relative to their less sustainably minded peers to weather adverse conditions while still benefiting from a positive market environment. And because of this, it is becoming increasingly critical that sustainability be an important investment consideration in portfolio construction. Institutional investors have been leading the way for some time – particularly in the Nordics, where they’ve been innovating in the space since the 1980s – by investing in those companies that are creating businesses of enduring value. And today, now more than ever, ESG issues matter to investors. Issues like climate change, information security, gender and racial diversity, and social equality are playing a growing role, as they should, in company success.
However, the question around ESG performance is as old as when ESG data first emerged. There is no evidence that investors need to sacrifice returns should they choose to invest in companies with a strong ESG focus as compared to companies that do not take ESG practices into consideration. Indeed, multiple studies have identified a positive link between ESG integration and various measures of corporate performance.
Understanding this correlation helps drive larger ESG adoption and will certainly bring it fully into the mainstream. The latest market volatility and uncertainty reinforces my conviction that companies with strong ESG characteristics show more resilience during market downturns. In Q1 2020, Morningstar reported that 51 of 57 sustainable indices outperformed their broad market counterparts, and MSCI reported 15 of 17 of their sustainable indices did the same. While these are obviously limited data points, we saw similar findings in prior downturns in 2015-16 and 2018. Peeling back the onion, as investors, we look to explain this resilience. In fact, there is evidence of a correlation between sustainability and traditional factors such as quality and low volatility factors, which tend to provide downside protection in market selloffs. That would certainly explain it.
Another interesting thing to note is that there has been increasing investor preference for sustainable assets since the beginning of the year. In Q1, global sustainable mutual funds and ETFs attracted USD $40.5 billion in new assets, a 41% increase YOY, which of course begs the question: Is this related to the pandemic and, if so, how are investors altering their perspectives and investment choices.
The pandemic’s devastating effects on all parts of our lives, professional and personal, underscore our vulnerability as individuals and as a society. Further, we see just how interconnected we are, especially in terms of commerce and trade. Looking at percentage growth rates of recent ESG flows, it may well be that the virus could prove a tipping point for ESG. Take the following three examples:
Access and Affordability – These criteria for companies address the ability to ensure broad access to their products and services, specifically in the context of underserved markets and/or populations. It includes the management of issues related to universal needs, such as the accessibility and affordability of health care, financial services, utilities, education and telecom. A prime example of this might be drug pricing once a vaccine or treatment is ready to be marketed.
Labor Practices – This category addresses the ability to uphold commonly accepted labor standards in the workplace. This includes minimum wage policies and provision of benefits, which may influence how a company trains, attracts, retains and motivates its workforce. Clearly, in this new area of remote and flexible working hours and growth of shift work, some companies may become more progressive as a way to differentiate themselves.
Employee Health and Safety – This area relates to a company’s ability to create and maintain a safe and healthy workplace environment free of injuries, fatalities, and illness. In pre-pandemic times, this would have been addressed by implementing safety management plans, developing training requirements, as well as how companies ensure the physical and mental health of their team through technology, training, corporate culture, regulatory compliance, monitoring and testing and PPE. Now it’s a much bigger challenge in the new age.
Also, interesting to note is how many ESG funds outperformed traditional funds during market sell-offs. We haven’t been able to test this case as the growth of ESG strategies pre-pandemic has happened in generally benign market periods. However, recent studies have measured the performance of shares in public companies, globally valued at more than $500 million, in which climate solutions generate at least 10% of revenues and looked at the 140 shares with the highest ESG scores and values above the global average. The study was conducted in two parts, measuring share growth from December 2019 and February 2020 compared to March 2020, with the latter period including market volatility. The climate-focused stocks outperformed others by 7.6% from December and by 3 % from February. High ESG scoring shares beat others by about 7% for both periods. In another study, Morningstar found that sustainable and ESG equity indices outperformed conventional indices in the Global Europe and US large-cap categories in the month to 20 March 2020. These studies suggest that portfolios with ESG integration provide good downside protection when markets are struggling. In fixed income, specifically in emerging market debt, the ESG equivalents of the broad market indices showed an outperformance during March 2020. This could well be something to continue to monitor as we anticipated more volatile markets ahead.
Finally, while ESG is growing in terms of the breadth of managers and strategies, investors should carefully evaluate whether adopting ESG makes sense for their portfolios and whether such investments aligns with their goals and values. But ESG is certainly not something to be ignored, and definitely here to stay, particularly in these times more than ever.