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.
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.
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 ‘Environmental, Social and Governance’ (ESG) was coined1, 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 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.
ESG has been embedded into equities the longest. Company engagement started decades ago, through voting and the rights and responsibilities that come with being a shareholder. Investors traditionally saw ESG analysis as a risk management tool, but its value has become much broader.
“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.
Companies adopting sustainable business practices are now being rewarded. In the recent sell-off caused by COVID-19 fears, many strategies with higher ESG ratings comfortably outperformed their benchmarks, according to Reuters (see Figure 1). Separate research from Bank of America Merrill Lynch between February 19 and March 25 estimates the top 20 per cent of ESG-ranked stocks in the US outperformed by over five percentage points.3
Figure 1: Performance of ESG strategies vs non-ESG strategies, March 2020
Corporate leaders in ESG often focus on the sustainability of their business models. Companies with more sustainable supply chains, for example, were better able to manage through the early months of the COVID-19 crisis relative to others with efficient, 'just in time' systems.
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”.
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”.
A more complete picture
Translating non-financial information into metrics that offer insight into financial performance can be a real challenge – requiring a step change from traditional company analysis which has, historically, been a separate skillset.
“I’m expecting to see those skillsets converge,” says Paul LaCoursiere, global head of ESG research at Aviva Investors. “Think about ESG from a financial or asset valuation perspective. If it’s relevant there, it means that all analysts should be thinking about it and including it in their analysis, whether that’s done to identify risk or opportunities. ESG should be joined up with the more traditional financial modelling that analysts have been doing for decades.”
Furthermore, although ESG integration has largely focused on equities, LaCoursiere sees this as outdated. “Our view of ESG risk is that it’s agnostic to the part of the capital structure you’re investing in. In other words, you’re analysing the company, and the risk is relevant whether you’re investing in senior unsecured debt, subordinated debt or the equity,” he says. “There could also be a different level of sensitivity or a different magnitude in terms of the ESG effect on pricing in credit relative to equities, but you’d expect the relationship to be correlated across equities and credit.”
Investors’ engagement approach should be equally uncompromising regardless of whether you’re a bondholder or shareholder, adds Rachel Harris, senior investment director at Aviva Investors. She believes bondholders have as much power to affect changes by working with company management as equity investors, particularly for large-cap, investment-grade companies. “They are every bit as reliant on the debt capital market as they are on the equity capital market,” she says.