Consideration of environmental, social and governance criteria was once driven by ethical forces. Now investors are discovering how it plays a key role in broader financial performance and managing volatility.
Increasingly, investors are embracing ESG, a framework for investment based on environmental, social and governance criteria. There are two motivations. One is based on the spirit of responsible and sustainable investing—supporting a company’s low carbon emissions or gender equality, for example, through capital allocation. The other is to mitigate risk and generate incremental returns, and there is a growing body of research that suggests that focusing on ESG issues can create long-term value. “Challenges such as climate change mitigation, labor force management and healthy corporate governance practices can have meaningful implications for long-term performance,” says Chris McKnett, Global Head of ESG Business at
State Street Global Advisors (SSGA).
Once seen as vague and peripheral, ESG is progressively becoming a core tenet to the risk-return equation and to goals-based investing. Historically, investors practiced socially responsible investing by excluding investments that didn’t meet sustainable or social standards. The success of constrained portfolios that align with such principles and policies is decidedly mixed. While many still follow this approach, most investors’ objectives are to add return and reduce investment risk, and they’re finding that ESG can do the job. A recent survey by SSGA on ESG adoption found that 84 percent of institutional investors are satisfied or very satisfied with the financial performance of their ESG strategies, and 69 percent say that ESG has helped to manage volatility. Performance is a motivator, as 75 percent expect the same returns from their ESG investments as their non-ESG investments.
The rise of interest in ESG is driven by a combination of ethical and financial forces in the market. ESG is becoming a secular trend as climate change, workplace diversity and corporate governance become more publicly prominent issues. Client demand is a powerful motivator for investment managers. Pension participants themselves are requiring more ESG options from plan sponsors, and regulations and legal developments are creating a more accepting and enabling environment. Managing headline and reputation risk is also a prevalent reason to consider ESG.
A newer driver is the conviction that ESG factors play a key role in broader financial performance, and they can be used as a way to manage volatility within an investment portfolio. “Where earlier approaches focused on avoiding negative impacts, we are now examining how to allocate capital in such a way to create a positive impact,” says McKnett. This means incorporating ESG themes into investment decisions by tilting portfolios toward companies that have the attributes that investors want exposure to. The objective is to deploy capital to create, or reinforce, positive impact with the aim of achieving market-like returns. There is increasing evidence in academia and in the industry that supports the investment thesis of ESG: ESG-based investment products are more seasoned and have longer track records, as well. “As ESG gets talked about more, researched more and practiced more, you see increasing levels of sophistication for integration, as well as more robust tools and analytical processes for investors to use,” McKnett says.
Macro drivers are also adding a tailwind, as investors use ESG analysis and data to understand systemic transitions in the global economy, such as the economic and investment effects of climate change. “That’s really the intersection between ESG and traditional investing that brings a lot of investors, who wouldn’t necessarily identify as socially responsible or ethical, to ESG,” says McKnett. “It will help them to position their portfolios for the future.” —Howard Moore