One of the major investment management trends of recent years has been the explosion of interest in Environmental, Social & Governance (ESG) investing. Whether you’ve heard of it already or not, it’s become a legitimate consideration for company owners, their shareholders and fund investors. There is no doubt it will continue to gain momentum as a key determinant of investment choice.
Whether describing this form of investment style as sustainable, green, ethical, impact investing, socially responsible or ESG, the key premise of all the above is for the investor to select funds with an eye on the good environmental, social and corporate governance of the funds underlying holdings, in addition to the usual financial considerations of an investment decision.
This has become a particularly hot topic in the last year or two as the younger global population, and higher number of people in general, push back against issues such as climate change, carbon emissions, slave labour, gender diversity, data security and corporate governance amongst a multitude of other ESG factors. Notable recent events such as the Volkswagen emissions scandal, Parkland high school shooting in Florida or Facebook’s data control breach have led to investors questioning whether their portfolios include exposure to gun manufacturers or morally debateable organisations.
In fact, to get a gist of the general direction in which this is all heading, Larry Fink, Chairman & CEO of US asset management giant Blackrock, who manage $6.3 trillion of investor assets, and probably a small part of your own portfolio, recently said:
“…a company’s ability to manage environmental, social and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process”
i.e. Get with the ESG programme, or we won’t be investing with you.
So how do you go about investing with ESG criteria. Well, in the past, the only real way to gain access to an ESG investment was to invest in the very small number of funds that specifically went out of their way to:
Negative Screen – Removing shares from the fund portfolio which fail ESG criteria, for example, tobacco, gambling, alcohol or mining stocks. However, this didn’t necessarily make you an ESG investor, it just made sure you didn’t invest in the worst offenders.
Positive Screen – Selecting shares for the fund portfolio whose companies have made a commitment to responsible business practices, that produce positive products and services, or that address environmental or social challenges.
The problem historically is that the small number of available ESG investment fund choices plus the screening out of many larger company shares from fund portfolios meant that ESG investing was a specialist objective often tagged with being high risk and low return in comparison to the overwhelming choice of non-ESG alternatives. The choice was clear. If you had any concern for ESG issues, you had to forfeit fund choice and possibly investment returns.
However, this has changed in recent years and three observations have accelerated an improvement.
The World Is Changing
Issues such as extreme weather, corruption, tax transparency, privacy & data security, mass migration and corporate governance have not only become more important to many people, but their increasing frequency has led to new risk factors for organisations. Think about it, if a company fails to consider the impact of gender diversity, data security or the consequences of their high carbon supply chain, is that likely to protect the company and its profits from future threat, or create a risk for the investor down the line? It is now believed that ESG issues can impact future profitability and share value, so companies and investors are taking it more seriously.
Investors Are Changing
Over the next two or three decades, the millennial generation (those born in the early 80’s to late 90’s) could invest between $15 trillion to $20 trillion into US domiciled ESG investments, roughly double the size of the US equity market1. And in a study by Morgan Stanley, 84% of millennial investors said that they are interested in sustainable investing2.
“We’re in the middle of a $30 trillion intergenerational wealth transfer from baby boomers to their children. And those kids – not really millennials only, but people from 25 to 40 years old – simply think about their investment decision differently” – Dave Nadiq CEO of ETF.com
It’s clear from the research that younger investors are more aware of ESG issues than their parents and as wealth passes to them they’re more inclined to reinvest with ESG factors front and centre.
Data & Analytics Are Changing
As with any industry or profession, technology is helping to improve services, products and processes. Better data from companies together with better ESG research and analytics means that there is more access to ESG metrics which makes it easier for investors and advisers alike to rank shares and funds along the good to bad ESG spectrum. Technology has given investors the information that they could only have dreamt of getting their hands on even 10 years ago and companies like Sustainalytics are happily providing investors and institutions with the data they crave.
And it is the third of the above changes that currently affects me the most as an adviser. As a firm, we pay to access detailed fund data and analytics provided by Morningstar Inc. Their adviser software incorporates fund ratings and analysis, which over the years has put more and more information in my hands instantly. Information that only 10 or 15 years ago would have been unavailable, or would have cost multiple thousands to access.
Morningstar, in conjunction with Sustainalytics, introduced ‘sustainability’ fund ratings in 2016 and at the 2018 London Morningstar Investment Conference, which I attended earlier this month, announced the availability of new ‘Carbon Risk’ scores on funds, which determine whether the aggregate carbon emissions of companies within the fund are negligible, low, medium, high or severe.
But notably, Morningstar’s analysis and ratings are not restricted to just specialist ESG funds. Scores and ratings are provided for any type of fund, so it is now perfectly possible to create a fully diversified global portfolio by choosing the most sustainable fund within each sector, rather than having to choose an outright ESG fund, which in isolation might not meet an investor’s overall need for risk and diversification.
We’re expecting to have access to Morningstar’s new carbon risk ratings during the summer. We’re yet to fully assess the fund research and analysis in great detail, but we’re keen to construct an ESG model fund portfolio option for our clients once available. This will offer investors the opportunity to invest part or all of their assets with ESG factors present in the investment decision making process.
1 Bank of America 2016 ESG Report