ESG Investing: Is Everything Else Irresponsible?
Responsible investing dates back as far as investing itself. In the 18th Century, Quakers and Methodists had both laid out clear guidelines to their followers over the types of companies in which they should invest, as did a range of other religious groups. Responsible investment became more formalized in the 1960s around the time the mutual fund industry started to gain acceptance. Questions around responsible investment reflected the social issues of the day, including the rise of the civil rights movement. It has continued to evolve as those demands from society have changed.
ESG (Environmental, Social, and Governance) investing refers to a class of investing that is also known as “sustainable investing.” “Sustainable Investing is an umbrella term for investments that seek positive returns and long-term impact on society, environment, and the performance of the business.
Notably, there are several different categories of sustainable investing, including impact investing, socially responsible investing, ESG, and values-based investing. Investors typically assess ESG factors using nonfinancial data on environmental impact (such as climate change and carbon emissions), social impact (including items such as employee satisfaction), and governance attributes (such as board structure). A key question is whether investors can “do well” in their investments while at the same time “doing good” from a societal perspective.
How Big Is ESG Investing?
Globally, the percentage of both retail and institutional investors that apply environmental, social, and governance (ESG) principles to at least a quarter of their portfolios jumped from 48% in 2017 to 75% in 2019. Reportedly, the largest amount of sustainable investing assets is in Europe, totaling $14.1 trillion, followed by the United States with $12 trillion. According to various sources, from 2014 to the beginning of 2018, assets under management with an ESG mandate held by retail and institutional investors grew at a four-year compound annual growth rate of 16% in the United States.
The Deloitte Center for Financial Services (DCFS) expects client demand to drive ESG-mandated assets to comprise half of all professionally managed investments in the United States by 2025. According to the DCFS, investment managers are likely to respond to this demand by potentially launching up to a record 200 new ESG funds by 2023, more than double the previous three years.
The International Monetary Fund estimates there are now more than 1,500 equity funds with an “explicit sustainability mandate.” These funds control nearly $600 billion in assets, up from roughly $200 billion in 2010. Overall, ESG-listed funds still have some way to go before becoming mainstream, representing less than 2% of the total investment fund universe. A hurdle to making sustainable active management funds more widespread is anecdotal evidence that their fees are often higher than those of other active funds, according to the IMF research.
Issues with The ESG Approach
While adopting an ESG approach and investing in ESG funds sounds laudable, there are some concerns about the transparency and quality of ESG disclosures. For example, from the company perspective, most ESG reporting by US companies is voluntary, and the content of those reports is left to company
discretion. According to research by Christensen, Hail, and Leuz (2019), a review of accounting and finance academic work showed that there currently is substantial variation in disclosures. This situation makes objective comparisons of companies’ ESG practices quite difficult for investors.
Looking at investment managers, a large number of them commit to such initiatives as the Principles for Responsible Investing. Still, the extent of actual implementation is not clear, as the large majority of asset managers do not disclose precisely how ESG factors inform their investment decisions.
Finally, there is considerable divergence in the metrics and methodologies used among ESG data providers. There is no list of agreed-upon ESG issues among the data providers. Research by Gibson, Krueger, Riand, and Schmidt (2019), highlights that ESG ratings diverge considerably. According to the research, the average correlation between overall ESG ratings of the six major providers of ESG data was less than 50%.
Morningstar has found that ESG implementation has not been defined consistently, partly because ESG investing is evolving. In the asset management industry, where active management faces competitive pressure from index investing, ESG strategies have been the bright spot in terms of new funds being launched and receiving inflows. This raises the question of, are funds labeling themselves as ESG in order to attract assets?
Does ESG Investing Outperform?
So, the $64,000 question is, can one do well by doing good?
Recent research demonstrates that ESG metrics may, in fact, aid the quest for alpha. The study backtested ESG metrics for materiality and found that a strategy that solely based its investment decisions on these metrics outperformed a global composite of stocks, strengthening the case for an active ESG investment strategy. In its October 2019 Global Financial Stability Report, IMF researchers found the performance of “sustainable” funds is comparable to that of conventional equity funds. “We don’t find conclusive evidence that sustainable investors underperform or outperform regular investors for similar types of investments,” Evan Papageorgiou, an author of the research, and deputy division chief in the Monetary and Capital Markets Department of the IMF told CNBC Wednesday.
Morningstar found that 41 of the 56 Morningstar’s ESG indexes outperformed their non-ESG equivalents (73%) since inception. Morningstar noted that performance across the range tends to be strong. ESG indexes also favor companies with healthier balance sheets, stronger competitive advantages, and lower volatility than their mainstream counterparts.
In summary, while what makes an ESG company appears to be in the “eye of the beholder” today, it does not appear that investors give up a potential return by adopting ESG investing principles.
Sources:
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