A recent report by the US SIF Foundation revealed that investors held USD 17.1 trillion in assets chosen according to ESG criteria at the beginning of 2020 - up from USD 12 trillion just two years earlier.
In addition, a white paper prepared by the Morgan Stanley Institute for Sustainable Investing found that from 2004 to 2018, the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds.
The same study also pointed out that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class. Even in years when the markets were turbulent, such as in 2008, 2009, 2015, and 2018, traditional funds had significantly larger downside deviation than sustainable funds, meaning they had a higher potential for loss.
It seems, then, that not only is ESG investing on the rise, but sustainable funds also hold the potential to yield returns that are at least as good as those of more traditional ones.
But what exactly sits behind the ESG abbreviation?
What is ESG Investing?
In brief, Environmental, Social, and Corporate Governance (ESG) refers to the three central factors in measuring the sustainability and societal impact of a company.
Each of the three pillars may include a broad variety of aspects of a business’ operations that are important to a potential investor. Below are some considerations they may look at ahead of deciding whether to commit to a company or not.
- How a company mitigates its GHG emissions
- How sustainable its products are
- How it deals with recycling and waste management
- How it sources its products (e.g., does it use fair trade suppliers)
- Does a company participate in community development
- Does it consider diversity and equal employment opportunity in its hiring process
- Does it prioritize human rights anywhere it does business
- Does it support its employees’ training and development
- Is executive pay at a company reasonable
- How diverse is the board of directors
- How responsive is the board to shareholders
- Is there financial and accounting transparency
A range of sustainability challenges unseen before is introducing new risk factors for investors. Sea level rise on the environmental side, privacy and data security issues on the social one, and regulatory pressure pertaining to the governance side of a business, have all emerged as considerations that need to be evaluated by modern investors.
With better data from companies combined with better ESG research and analytics capabilities, we are seeing more systematic, quantitative, objective and financially relevant approaches to ESG key issues. Better data and analytics have paved the way for numerous studies that explore ESG investing, i.e. the availability of more precise information has the capacity to inform future decisions taken in relation to ESG.
Morgan Stanley Bank recently conducted a survey that found that nearly 90% of millennial investors were interested in pursuing investments that more closely reflect the values they hold. Such investors also tend to be more activist investors, participating at shareholder meetings and actively working to influence company policies and practices.
Consequently, the changing demographics of investors means that companies will place more emphasis on their ESG credentials, in order to attract the attention of these investors. In doing so, one can expect that ESG investing will establish itself as a mainstream practice rather than a niche strategy.
And from this follows that the ESG investing concept as a whole will crystallize itself and some obscurities around ESG rating methodologies will be removed. As we shall see below, this is one of the most commonly cited challenges to ESG and its clarification will be key to its future growth.
Challenges and Criticisms
Socially responsible investing does not come without its criticisms. One of ESG investing’s harshest critics was the late Milton Friedman, the most prominent figure of neoclassical economic theory. Friedman argued that evaluating a stock should focus on the company’s financial value and bottom-line profits, period, and that socially responsible corporate expenditures are nearly always “non-essential expenses” that erode corporate and shareholder profits.
The fact that there are conflicting views about whether ESG investing yields superior returns is in itself a challenge to this type of investment. The truth is that different studies report different findings.
For instance, the OECD’s latest report notes that while “loosely defined” metrics seem to indicate that environment, social, and governance (ESG) investing provides superior returns, “a more in-depth analysis suggests that financial performance based on ESG ratings is mixed and there is little evidence of consistent overperformance in recent years.”
The lack of standardized reporting and low transparency in ESG rating methodologies presents another challenge. The aforementioned OECD report acknowledges that these “limit comparability and the integration of sustainability factors into the investment decision process.”
It added that “current market practices, from ratings to disclosures and individual metrics, present a fragmented and inconsistent view of ESG risks and performance.”
We discuss what makes ESG ratings problematic at a greater length in another article.
This is where TenderAlpha’s data can assist in overcoming the issues around the objectivity of rating metrics, at least to a degree. In our own green contracts detection methodology, we use only official government sources, leaving no doubt whatsoever of the data’s veracity.
Thus, transparency over exactly how much governments and private businesses alike are committed to the green idea can be achieved. This, in turn, could be seen as a step in the right direction when it comes to evaluating an organization’s ESG performance and will contribute to its more objective rating.
Why ESG is Growing
Despite criticisms leveled at ESG for not being directed towards profit and only profit, some studies show that the growth of ESG investment strategies is directly related to their ability to generate alpha. It has been discovered that during the market downturn in Q1 of 2020, ESG passive and active strategies outperformed significantly, leading to record inflows.
During the same period, 24 of 26 ESG index funds outperformed their conventional index benchmarks across US, non-US, developed markets, and emerging markets, according to Morningstar.
Last but not least, the numerical estimates for the millennial generation’s investment commitment to ESG indicates the potential for a massive growth in the US equity market. Over the next 20-30 years, it is expected that between USD 15 trillion and USD 20 trillion will be put into US-domiciled ETFs.
Furthermore, as mentioned in one of our previous articles, millennials are asking more of their investments and are generally more concerned about their ethical implications. That being said, there is every reason to believe that more thought will be put into the effect each investment might have on the wellbeing of both the planet and the people.
To wrap up, there is some evidence showing that ESG funds perform at least as well as traditional ones, which clearly shows the potential of ESG investing. Then, there is also the feel-good factor of investing in a business that strives to act ethically and respectfully in everything it does.
At the same time, much more work needs to be done before companies can be properly assessed for their sustainability, as neither the factors nor the way they should be measured are exactly clear.
Still, the growing interest in this type of investment almost certainly means that, in order for investors’ needs to be met, concerted efforts will be made to put together objective and standardized metrics that will make it easier to monitor the progress each business makes. In all likelihood, this will further strengthen the credibility of ESG investing and draw the attention of even more representatives of the investment community.