Once dismissed as a virtuous endeavour that compromised investment returns, the ability to gain a more holistic view of risk by considering environmental, social and governance factors is increasingly appreciated by investors. We assess the evolution of ESG across asset classes, as well as its role as a risk mitigator and opportunity spotter.
With money pouring into the responsible investment sector, or funds closely tied to it through environmental, social and governance (ESG) integration, investors are making a clear statement with their money. They either want to do some good with it, think that by doing so they will be rewarded, or both.
Since the term ‘ESG’ was coined 16 years ago in Who Cares Wins, published by the United Nations Global Compact and the Swiss Federal Department of Foreign Affairs,1 sustainable investing assets under management now total about US$14 trillion in Europe and US$12 trillion in the United States, according to Deloitte.2 While the US has historically trailed Europe in ESG implementation, the consultancy believes a turning point is around the corner. It estimates ESG-mandated AUM could grow almost three times as fast as non-ESG AUM in the US, accounting for half of all professionally managed investments by 2025.
Despite the rapid progress, there have also been some notable barriers. For many, the focus so far has been on rankings that are often static and uniformly applied for all sectors, based on data that may not be relevant. An ESG score, however comprehensive, is far from a complete picture – within assets, sectors and countries – from which to base investment decisions. Engagement has also traditionally taken a siloed approach, mainly focused on equities, while sidestepping investments elsewhere in the capital structure. And while attempts have been made to consider forward-looking information into the investment process, they have often been applied on an idiosyncratic basis rather than in an integrated way.
In this article, we explore the growing importance of ESG to investors; charting its course from its ‘dark green’ screening days through to today and the impact of stewardship, engagement and its influence on the drivers of returns. We also consider the progress needed to address some of the shortcomings when translating ESG factors into asset allocation decisions. Investors, too, must advance their understanding of how the ‘E’, the ‘S’ and the ‘G’ relate to each other and to financial metrics in a dynamic process that is both suitable to the particular investment as well as being harmonious within the broader portfolio.
Beyond risk mitigation
Of all the asset classes, ESG has been embedded into equities the longest. Indeed, company engagement started several decades ago, through voting and the rights and responsibilities that come with being a shareholder.
However, investors traditionally saw ESG analysis as part of their risk management process. It still plays that role, but its value is much broader. “In my view, it is more a way of identifying the most meaningful scenarios of how ESG is likely to help meet a corporate strategy. The real lens through which to assess ESG is ‘is this company’s business model sustainable?’,” says Jaime Ramos-Martin, global equity portfolio manager at Aviva Investors.
An increasing amount of data shows that companies adopting sustainable business practices are rewarded by financial markets. In the recent sell-off caused by COVID-19 fears, many strategies with higher ESG ratings exhibited less volatility to outperform their respective benchmarks, except for active US large-cap equity funds, according to Reuters (see Figure 1). Separate research from Bank of America Merrill Lynch covering the US market between February 19 and March 25 estimates the top 20 per cent of ESG-ranked stocks outperformed by over five percentage points. This trend persisted on a sector-adjusted basis.
Companies with higher ESG scores are more likely to be found in technology, healthcare or consumer staples, which have fared better than other sectors such as airlines in recent months. “There is an element – by design of ESG funds and the nature of this crisis – that favours certain sectors,” says Ramos-Martin. “Then there is true ESG resilience.”
Corporate leaders in ESG often focus on longer-term resilience and the sustainability of their business models. These attributes may offer downside protection, he adds. Take supply chain management, which forms a significant part of a company’s ESG resilience. Companies with more sustainable supply chains were better able to manage through the early months of the COVID-19 crisis relative to others with efficient, ‘just-in-time’ systems.
Given the unprecedented fiscal and monetary support to tackle the economic fallout from the pandemic, there will be a renewed focus on corporate governance. Practices like excessive tax optimisation, poor labour and community relations, and poor environmental compliance will be harder to defend. In contrast, companies with stronger ESG credentials are more likely to meet the conditions to receive government support through stimulus packages, Ramos-Martin argues.
Diversification benefits are possible too. According to ESG Performance and Disclosure: A Cross-Country Analysis published in 2019 by the European Corporate Governance Institute, ESG also has “a small, but statistically significant, impact on reducing volatility, which may mean there are portfolio diversification benefits from high-quality ESG investment in certain situations”.