There’s a shift toward ESG-focused strategies when it comes to investing
In today’s economy, cultural and socio-economic issues have given the consumer and individual investor a voice in corporate boardrooms. Large mutual fund managers and pension funds are taking their clients’ environmental, social and governance (ESG) concerns and demanding implementation of better corporate practices. In the modern world, well-run companies that manage ESG risks have a better chance at securing financing to fund future growth.
ESG encompasses factors such as how a company manages its carbon emissions, uses of renewable energy, fair trade ingredient sourcing, workforce development and labor standards, equal pay initiatives and anticorruption practices, to name a few. The E, S and G are referred to as “sustainability” initiatives and help tell the story of how a company will remain competitive in the future.
For investors, ESG risk analysis serves as a framework and overlay to traditional security analysis that dives much deeper into a company’s operations. These risks may be hard to quantify because they do not typically show up on financial statements. Companies that fail to mitigate ESG risks could experience a lasting and meaningful impact on their bottom lines and fail to attract capital from the new investors.
A seismic shift toward ESG-focused strategies is underway. At the beginning of 2018, it was estimated that $12 trillion of managed assets in the U.S. had implemented ESG screens. This figure is up $4 trillion from 2016 and $8 trillion from 2012 (US SIF). Mutual fund companies have seen record inflows over the last three years into ESG strategies. In 2018, the number of available ESG-focused mutual funds and ETFs jumped by nearly 50 percent.
A large study on over 2,000 ESG portfolios showed that returns are comparable with non-ESG focused portfolios. The study further found that 88 percent of companies with sustainability practices had better operational performance and cash flow. Out of the eleven GICS sectors, nine showed lower earnings volatility from stocks with high ESG scores. Overall, 90 percent of the results showed that sustainability initiatives had a neutral or positive effect on investment returns.
The fixed income side of ESG investing is also gaining momentum. Social and green bonds pay fixed interest like traditional bonds and go toward funding environmental projects and social impact themes. In 2016, inflows into social bonds totaled $2.4 billion. In 2018, however, social bonds took in $13.4 billion; a tremendous increase in just three years. Year-to-date through August, social and green bonds have attracted about $8.4 billion, with only 6 percent coming from the United States.
Impact bonds, on the other hand, are smaller in scope and are issued by nonprofits and foundations with the investor’s return being commensurate with the profitability of the underlying project.
In Europe, public companies with over 500 employees are required to report on ESG factors. Out of 95 stock exchanges worldwide, 86 are members of the Sustainable Stock Exchanges, which had just six member exchanges in 2012. Seven of these stock exchanges now require member companies to report ESG factors.
The United States is somewhat behind the curve when it comes to ESG reporting. The NASDAQ issued limited guidance on ESG reporting in 2017. This guidance was revised just this past May to fit a greater audience of member companies. While a little late to the scene, a strong push by investors will likely continue to propel the ESG movement forward in the U.S. in the years ahead.
The expectation is not necessarily for ESG portfolios to outperform non-ESG portfolios; but rather for investors to match their personal values with competitive returns while creating a better world in which to retire.
Andrea McKinney is vice president and wealth management advisor at Central Trust Company.
