ESG investing, or Environmental, Social and Governance investing, is become increasing popular. But what is it, and why do investors want to invest in companies which rank high in ESG factors? What are the benefits of ESG investing?
What is ESG Investing?
ESG is using your money to invest in companies whose business practices align with your values. ESG investing can mean filtering out companies with business practices you don’t want to support, or it can mean putting your money into companies which have business practices which align with your values. Either way, investors have been reluctant to screen out profitable companies which may not meet their ESG requirements because they didn’t want to give up potentially higher returns on their investments. However, ESG investing has been gaining traction recently and may gain even more traction due to the effects of the COVID-19 pandemic.
There will be many lasting effects of the COVID-19 pandemic, even after the health risks are mitigated. Our hearts and thoughts go out to those impacted by the virus, and we give a special thanks to our healthcare and essential workers on the front lines. We anticipate long-lasting economic and societal impacts from the pandemic. One silver lining may be an increased awareness of the inherent value of doing the right thing in business practices. The benefits of ESG investing may become more apparent to more people due to the dramatic shifts in businesses.
To better understand ESG investing, here is a breakdown of what each ESG factor measures:
1) Environmental Factors:
Environmental factors include how a company’s activities impact the environment, both locally and globally. Examples would be how a company mitigages it’s greenhouse gas emissions, whether the products are sustainable, and if it uses natural resources in a sustainable way.
2) Social Factors:
Social factors include how a company’s activities impact people and communities, both inside and outside the company. Examples would be does the company consider diversity adn equal employement activities when hiring and promoting employees, does the company priotize human rights wherever it does business, and does the company participate in community development in the local community.
3) Governance Factors:
Governance factors include decisions made by a company’s leadership and board of directors. Examples would be whether executive pay is reasonable, whether leadership is responsive to shareholder concerns, whehter leadership is responsive to stakeholder concerns, and if the leadership is diverse in its representation.
ESG strategies expected to outperform
The growth of ESG investment strategies are directly related to their ability to generate alpha, meaning a return greater than the return which would be earned with a more passive investment strategy. During the first quarter (Q1) 2020 market downturn, ESG passive and active strategies outperformed significantly, leading to record inflows. In Q1, 24 of 26 ESG index funds outperformed their conventional index benchmarks across US, non-US, developed markets, and emerging markets, according to Morningstar.
For example, the S&P 500 ESG Index, MSCI ACWI ESG Leaders Index, and Russell 1000 ESG Index each outperformed their traditional, non-ESG counterparts. The results remain favorable even when looking across all ESG equity open-ended or exchange-traded funds (ETFs) in the United States. 44% of the ESG funds ranked in the top quintile of their Morningstar category and only 11% finished in the bottom quintile.
The “S” in ESG is increasing in recognized value
Companies with superior human capital practices and policies may strengthen long-term competitive advantages through stronger employee morale, customer loyalty and brand value. George Serafeim, Harvard Business School Professor, commenting on Corporate Resilience and Response During COVID-19 notes that “companies responding in a way that protects employees (avoiding lay-offs, paying sick leave), manages supply chain risk (safety to avoid disruptions) and re-purposing operations to provide solutions (producing masks, ventilators) had higher institutional money flows and less negative returns.” Increasingly, people recognize the positive correlation between a company that does well by all of it’s stake-holders and a company that is successful in the market place.
The importance of shareholder engagement
ESG issues continue to be important shareholder engagement topics for institutional investors. Data shows a noticeable upward trend in investors supporting environmental and social shareholder proposals and putting pressure on the Board of Directors at pubicly traded companies to prioritize the ESG concerns of investors. We believe that investors will increasingly deploy shareholder engagement techniques to help drive shareholder value and push for positive change.
Environmental effects of ESG policies more evident
The International Energy Agency (IEA) warned that the economic fallout from COVID-19 could slow the transition to clean energy. Collapsing energy demand will likely have a near-term negative impact on private sector investment and falling prices on EUs emission trading scheme may decrease incentives for renewable energy investments. While this could slow near-term progress, long-term ESG pressures remain. Over the near-term, ASA revealed that air pollution, measured by nitrogen dioxide (NO2) levels, was 30% lower in March 2020 between Washington DC and Boston compared to the March average between 2015 – 2019. And European Space Agency’s Sentinel-5P satellite shows NO2 falling by as much as 40% in late January and early February 2020 relative to one year ago across industrial areas in Asia and Europe.
We believe that long-term green policies will continue to be enacted as the link between air pollution resulting from industrial activity and human health become more apparent. Debates in Europe and South Korea are underway with leaders working to include Green New Deal initiatives in post-pandemic recovery plans. Regardless of the outcome, the demand from investors to invest in companies who consider their effect on the environment will continue to be a significant factor.
Variability in ESG Performance:
There is additional research showing that there is a lot of variability in the way ESG strategies perform. Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds, a research paper published by Vanguard Investment Strategy Group’s Jan-Carl Plagge and Doug Grim in The Journal of Portfolio Management examines whether ESG equity fund strategies come with a cost in the form of lower expected returns, higher volatility, or both. The study concluded that “Overall, our findings suggest that ESG funds have neither systematically higher nor systematically lower raw returns or risk than the broader market.” There are many different ways to filter for ESG investing, and the various filters can have very divergent characteristics, which results in ESG investing alone being too broad of a filter to determine performance alone.
“Given these differences in risk-return outcomes and the high degree of heterogeneity in the construction and management of ESG funds,” Mr. Grim said, “investors should assess potential investment implications on a strategy-by-strategy basis.” In plain English, it means buyer beware. Just because an investment uses the label ESG does not by itself mean anything definative. It is important to look more closely at the specific investments you are considering to see if they align with your personal goals and are fundamentally sound investments.
Summary of the Benefits of ESG Investing
ESG investing is expected to gain popularity as businesses who consider the impact of their policies on all stakeholders are rewarded. ESG investing used to be viewed as a niche investment filter for certain investors, but was viewed as too limiting for most investors. It is evolving into a viable way to filter for companies which have the fundamental business policies in place to make the companies more profitable and better able to sustain potential bumps in the road over the long term.