ESG and the Future of Investing
Will a socially responsible population mark a paradigm shift?
Environmental, Social and Governance (ESG) funds seek to not only to produce financial gain, but also to have a positive lasting impact on society. The economic consequences of COVID-19, the continued push for social justice, as well as environmental concerns have bolstered investments in ESG. Globally, assets invested in ESG have risen substantially over the past several years, and stand at over $40 trillion in 2020.
Bolstered by a sustainability agenda across nations, and backed by regulatory and government support, European ESG funds pulled in a record $132 billion (€120 billion) in assets in 2019; inflow in the United States was $20.6 billion. Investment options for ESG are numerous, and include active and passive mutual funds, as well as ETFs.
The history of ESG investing began in 2004 when former UN Secretary-General Kofi Annan invited the CEOs of 50 major financial firms to participate in an initiative backed by the International Finance Corporation (IFC) and the Swiss Government. With the support of the UN Global Compact, the group’s directive was to investigate incorporating ESG into the capital markets.
Several reports emerged, including “Who Cares Wins,” which reinforced embedding ESG factors into investing, while the Freshfield Report showed how an ESG agenda could also be relevant for financial valuation.
Combined, these reports provided the basis for the launch of the Principles for Responsible Investment (PRI) and the launch of the United Nations Sustainable Stock Exchanges Initiative, with a goal to foster dialogue, identify key obstacles, and explore new emerging issues.
How do ESG funds fare as far as performance is concerned? Thus far in 2020, an S&P benchmark of these funds has outperformed the broader market index, primarily due to a large technology weighting in those funds. For the year-to-date through August 31, the S&P 500 ESG returned 12.63%, besting the 9.74% return of the S&P 500.
While big technology companies don’t seem to belong in an ESG fund, the blueprint provided by the UN in their Sustainable Development Goals also includes operational behavior — including corporate equality, fair pay, and access to healthcare — hence the inclusion of these companies in many ESG funds.
In today’s complex investment environment, what trends are evolving for ESG investing?
Climate change
From the recent fires on the West Coast of the United States to the shrinking of the Arctic shelf, headlines are filled every day with more examples of how climate change is affecting the planet.
Corporate executives are taking notice as well. Business Roundtable is an association of CEOs of leading American companies. The association released an updated statement of guidelines, supporting a proposal of reduced emissions in the U.S., and putting a price on carbon.
The shift marked a change from its prior principles, as these leaders seek to reduce greenhouse gas emissions and avoid the devastating effects of climate change.
Countries too are moving away from fossil fuels and toward renewable energy. Among them, Germany announced plans to end the use of coal-powered energy by 2038, while New Zealand has committed to producing 100% renewable energy by 2030.
Will the pandemic be the turning point toward a greener future? According to the International Renewable Energy Agency:
“This year was meant to be a turning point for climate and sustainable development, with 2020 marking the start of the decade of action. The unexpected pandemic, with its devastating consequences for communities and economies is upending plans, interrupting trends and testing assumptions.”
Green bonds
Sustainable investing is expanding beyond equities. Green bonds are designed to specifically support a climate-related or environmental project. In 2019, 479 green bonds were issued, a notable increase from the year before.
To help fund recovery from the pandemic, the EU recently announced $267 (€225) billion of green bonds. In the corporate world, JPMorgan Chase & Co issued $1 billion of green bonds to fund sustainable projects.
Growing Acclimation
As fixed-income investments begin to adopt sustainability standards, hedge funds are being pressured by investors demanding socially responsible investing. While hedge funds have been reluctant to adopt ESG strategies due to inconsistent data and tracking, activists are starting to pivot toward sustainability, taking on social and environmental issues.
Institutional investors are increasingly integrating ESG into their investment decisions. According to an annual survey, 42% of institutions surveyed had integrated sustainable investing considerations into their decision-making, up 91% since the survey was launched in 2013.
Standardization
There are already numerous mutual funds that are ESG focused, and many more — nearly 500 in 2019 — have added language allowing them to invest sustainably to their prospectuses. With so many options — Socially Responsible Investing, Thematic, Impact, Values-Based — how can you determine if a fund is truly following ESG principles?
A market benchmark is critical to compare a fund for return and risk characteristics. For ESG funds, quantifying sustainability standards is equally as important. To determine whether a company is sustainable, investors typically rely on rating agencies to grade companies on their ESG performance, and these results vary depending on the rating agency.
While environmental standards can be measured, it is more difficult to quantify social and governance objectives. There is no guarantee that a firm is abiding by a set of guidelines. Diverse factors such as carbon emissions, water usage, human rights, board composition, and shareholder rights need to be considered.
Regulation
As the sector grows, it faces additional scrutiny. Lack of consistent standards and reliable data have prompted the U.S. Department of Labor to consider whether private pension funds can invest in ESG vehicles.
Secretary of Labor Eugene Scalia stated the rule would provide “clear regulatory guideposts” and that “ERISA plans should be managed with unwavering focus… the retirement security of American workers.”
SEC Commissioner Elad L. Rolsman also highlighted concerns, particularly if a fund was “prioritizing environmental or social goals above the fund’s economic returns.” And in the European Union, how terms such as “green” and “sustainable” are used may be regulated by 2022. This increased scrutiny of the ESG investment landscape by regulatory agencies will drive demand for transparency and end “greenwashing.”
As income disparity and social injustice dominate headlines, ESG investing continues to gain momentum. More and more individuals are concerned about the impact of their investments. The future of ESG — as companies strive to combine positive sustainability with financial impact — will undoubtedly influence markets going forward.
COVID-19 and its socioeconomic fallout have highlighted issues such as climate change, income inequality, and diversity, further fueling interest in ESG funds. With so many options and so much at stake, does ESG belong in your portfolio?
Markets are in constant flux, and the only thing certain is continued uncertainty. To learn more visit quantumeconomics.io. This information is for educational purposes only and should not be construed as trading advice. Past performance is not an indication of future results.
