The Time for ESG Investing Is Now

Journal of Financial Planning: June 2021

 

Ryann Marotta, CFA, CFP®, is a senior portfolio manager responsible for the implementation and oversight of sophisticated investment strategies on behalf of clients. In her role, she develops relationships with clients to understand their unique financial situations and deliver portfolio solutions in their best interests.

 

JOIN THE DISCUSSION: Discuss this article with fellow FPA Members through FPA's Knowledge Circles. ​​

FEEDBACK: If you have any questions or comments on this article, please contact the editor HERE

In the realm of ESG investing, we know two things to be true: investor demand is increasing, and the supply of investment product is vast and bewildering. In 2020 alone, over $50 billion was added to ESG investment funds—more than double that of the previous year.1  Although opportunity abounds for those who stand ready to navigate the ESG waters, many financial advisers are still wary of properly researching and implementing ESG investment strategies for clients.

What Is ESG?

ESG stands for environmental, social, and governance, and is best thought of as a Venn diagram highlighting sustainability factors for a given company. Asset managers source data from companies to measure and analyze these factors, allowing them to create investment products favoring companies that compare relatively well.

As an example, an initial observation of Home Depot may not appear ESG friendly given its role of perpetuating endless home-construction projects. However, the company has identified numerous opportunities to become more socially responsible, including enacting strict policies upon suppliers to prevent the purchase of exploited natural resources, and instituting customer programs to reduce water consumption. Home Depot reports on these sustainability initiatives and asset managers have recognized it as a top-rated ESG company.2 

ESG investing is by no means a passing trend. In fact, the concept of impact investing predates modern financial markets with references in early religious texts that continue to guide investment philosophies today. Now known as socially responsible investing (SRI), this form of impact investing uses negative screens to exclude stocks in certain industries that do not align with an investor’s values. As the concept evolved, ESG investing was created to seek company data relevant to an investor’s values that may also be additive to economic value over the long term.

Since 1995, ESG investments have experienced a 14 percent compound annual growth rate, with near exponential growth occurring since 2012.3  As of the second quarter of 2020, ESG investment funds account for more than $250 billion.4 Looking ahead, this growth is expected to continue, with ESG investments forecasted to grow at almost three times that of traditional investments, comprising 50 percent of all managed investments by 2025.5

A Trifecta for Demand

The recent monumental investment shift into ESG products is the culmination of actions at every level: people, corporations, and governments.

Grassroots sentiment is evolving as extraordinary events become more ordinary. From natural disasters and movements for social justice to the current global pandemic, people are increasingly concerned about the well-being of their communities. Concurrently, changing demographics are bringing the millennial investor online with greater disposable income, and women are taking control of a greater share of the wealth market. These two investor segments are more likely to invest in ESG products.

Investors are growing increasingly aware of the power of their purse to support personal causes. Traditionally, people were guided to create impact through the expense portion of their income statement, donating to their preferred charities or spending at their favorite businesses. Today, however, people have greater access to direct their financial capital toward companies that share their values, whether from traditional banking products through a company like Aspiration Bank or extensive options for ESG investing.

Corporations have also shifted their position from only maximizing value for shareholders, which has eroded into short-term, quarter-by-quarter fiscal oversight, to incorporating other stakeholders, including customers, employees, suppliers, and communities. This departure from the decades-old economic norm was decreed in 2019 by the Business Roundtable, a group of nearly 200 U.S. CEOs led by Jamie Dimon, chairman and CEO of J.P. Morgan Chase, in its “Statement on the Purpose of a Corporation.”6  Although words do not always translate into action, many companies are taking steps to reduce carbon emissions, increase diversity and inclusion, and develop standards for corporate leadership. To increase transparency, these companies voluntarily report on these actions, thereby providing data for asset managers.

Asset managers are also taking note as they consider the future of investment allocation. Larry Fink, chairman and CEO of BlackRock, famously espoused in his annual letter to CEOs that “climate risk is investment risk,” and yet, “the climate transition presents a historic investment opportunity” due to the need for innovation and technology. Given his position as CEO of the world’s largest asset manager, he is not just shifting the direction of BlackRock, but all companies globally. BlackRock approaches their investment practice as a fiduciary to their clients and has integrated ESG factors into 100 percent of their active and advisory investment products.7

Governments are also forming public policy that supports ESG initiatives. The European Union is seen as a leader on this front, undertaking policies from online privacy and security to climate change. Under the Biden administration, the U.S. is expected to take action on similar policies as well. While China is woefully inadequate in some areas, it has joined other countries in making a commitment to achieve net-zero carbon emissions, which stands to be incredibly impactful considering its current title as the world’s leading carbon emitter. Of particular interest to investors, much of current global infrastructure is dated with upcoming projects expected to incorporate green improvements.

Collectively, these underlying actions across people, corporations, and governments are driving fundamental change in the investment landscape. As demand for ESG investments has increased, asset managers have risen to the occasion to supply the market with an abundance of product. Yet, financial advisers have been slow to adopt ESG considerations within their investment practice.

Barriers to ESG Integration

For all the recent advancements within the ESG realm, confusion on the subject among market participants persists. As ESG investing evolved, so did the definitions and scope of associated terms and metrics. This deluge of corporate ESG data allowed the investment industry to run rampant, and asset managers moved quickly to develop their own ESG solutions and adapt existing products to market to ESG-interested investors. As a result, no two products utilize the same inputs or approach, causing confusion even among investment professionals who are then wary to recommend these products to clients.

Across equity and fixed-income investments, investors view a lack of relevant data and limited understanding as primary barriers to ESG integration. However, it is voluntary for U.S. corporations to report on ESG metrics, and only large companies can commit the necessary resources, whereas smaller companies struggle and self-select out.

While this may be true today, industry leaders are working diligently to determine the relevancy of data and improve metrics to support clearer outcomes for investors. The need for globally unified reporting standards is gaining traction, and standard-setting groups are now focusing on reporting requirements to ease the burden across all companies while also supporting consistent and clear data. Similarly, CFA Institute is currently formalizing disclosure standards for asset managers for ESG products that will aid comprehension and comparison by investors.

Can Values Add Value?

Naturally, investors are also concerned about investment performance. The most principled tenet of investing acknowledges the relationship between risk and return. Over the years, ESG investing has become associated with market inefficiency in which financial gain is sacrificed for personal good. However, recent industry and academic studies suggest the opposite. Empirical evidence shows that ESG strategies offer better risk-adjusted returns over the long term with lower tail risk, lower overall volatility, and returns that often meet or exceed broad benchmarks.8 In addition, companies that score well on ESG metrics tend to have lower costs of capital.9

These studies reinforce logical intuition. Metrics that look beyond financial statements to better understand the story behind a company can often identify underlying opportunities and risks that support long-term performance. As examples, labor satisfaction can be an indicator for labor strikes or class action litigation, while investment in research and development to be more resource efficient can signal a move to overcome uncertain weather patterns.

A Path Forward for Advisers

While the investment industry works to overcome institutional issues, financial advisers must work to overcome their own behavioral biases related to ESG investing, and much like ESG considerations themselves, these biases are interconnected.

Since ESG investing is only recently gaining momentum toward standardization, education for advisers is lacking on the subject. Yet, that does not warrant shortcuts. As fiduciaries, financial advisers must look beyond the comfort created by the availability bias to properly complete due diligence and research on ESG investing. They must overcome the confirmation bias to consider secular shifts as companies update their purpose to incorporate stakeholders in addition to shareholders or define their plan to reach carbon neutrality.

Lastly, ESG investing presents a paradox of choice whereby it is easy to become frozen in indecision and turn away completely rather than perform the necessary due diligence to advance quality products from among the mass. This process will get easier as corporations, policymakers, and the investment industry coalesce on unified standards. Then, investors will have access to clear, relevant, and consistent data to make more informed investment decisions on ESG products.

ESG factors support a more holistic outlook for a company—much like the financial planning process for an individual—and when incorporated into investment strategies, they have the potential to deliver returns that are not just personally rewarding, but financially rewarding as well. As financial advisers serving clients’ best interests, the time for ESG investing is now. 

Disclaimer: This information does not serve as the receipt of, or as a substitute for, personalized investment advice. The opinions expressed are subject to change at any time due to the changes in the market, economic conditions, or tax regulations.

Endnotes

  1. See “Money Invested in ESG Funds More Than Doubles in a Year,” from CNBC, available at cnbc.com/2021/02/11/sustainable-investment-funds-more-than-doubled-in-2020-.html.
  2. Ibid.
  3. See www.b20Report%202020%20Executive%20Summary.pdf
  4. See “Passive Sustainable Funds: The Global Landscape,” from morningstar.com/lp/passive-esg-landscape?utm_source=corp_comm&utm_medium=referral.
  5. See “Advancing Environmental, Social, and Governance Investing,” from Deloitte at www2.deloitte.com/us/en/insights/industry/financial-services/esg-investing-performance.html/.
  6. See the full “Statement on the Purpose of a Corporation,” at system.businessroundtable.org/app/uploads/sites/5/2021/02/BRT-Statement-on-the-Purpose-of-a-Corporation-Feburary-2021-compressed.pdf.
  7. See Larry Fink’s 2021 letter to CEOs at blackrock.com/us/individual/2021-larry-fink-ceo-letter?gclid=CjwKCAjw9MuCBhBUEiwAbDZ-7iOLuOTQb9GeAModLRJD7dUfMRbVMyj2sCjPAKVY0xqbOEzejPssXRoCfxUQAvD_BwE&gclsrc=aw.ds.
  8. See “Aim Higher: Helping Investors Move from Ambition to Action with ESG Investment Approaches,” at statestreet.com/content/dam/statestreet/documents/Articles/aim-higher-helping-investors-move-from-ambition-to-action-with-ESG-investment-approaches.pdf.
  9. See “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” at smithschool.ox.ac.uk/publications/reports/SSEE_Arabesque_Paper_16Sept14.pdf.

 

Topic
Investment Planning