The evolution of ESG investing

FundsTalk

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Nearly 15 years after the term “ESG” was first coined, the vision —and the investment case – for environmental, social and governance investing is coming into sharper focus.

A recent report from Morningstar showed that 2019 was by far the strongest year on record for inflows into ESG funds in the UK, with more than £4 billion being invested (70% of which into actively managed funds). Over the past five years, assets under management in ESG products have doubled, and new funds are being created at an unprecedented rate.[1]

As we head into 2020, what are we learning about the relevance of ESG investing – how did it evolve from a “nice to have” element in a portfolio to an increasingly vital – and rewarding – approach to long-term investing?

ESG MILESTONES

What we now call ESG has its roots in Socially Responsible Investing (SRI) which dates back several decades. SRI is generally focused on ethical issues and uses“negative screening” to exclude concerns which might include tobacco, fire arms, or gambling companies. In 2004, Kofi Annan, then the UN Secretary, asked major financial institutions to partner with the UN and the International Finance Corporation in identifying ways to integrate environmental, social, and governance concerns intocapital markets – the resulting 2005 study, “Who Cares Wins”, marked the first use of the term ESG. The paper asserted that embedding ESG filters into investing would not only have a societal benefit, but made good business sense as well. Alongside it was the “Freshfield Report”, which further argued that ESG factors were relevant to financial valuation. 

These studies changed the landscape by expanding on the moral and ethical concerns of SRI, to take into account the financial impacts as well as societal implications of how a company operates. While not a part of traditional financial analysis, evaluating such factors as health and safety policies, water management, supply chains, and corporate culture started to be become more commonplace. 

The founding in 2006 of the Principles for Responsible Investment (PRI) solidified the movement toward ESG and to this day remains the world’s independent standardbearer, providing a “blueprint for responsible investment” for nearly 2,000 signatories worldwide.

ESG has its roots in Socially Responsible Investing (SRI) which dates back several decades.

THE RELATIONSHIP BETWEEN ESG AND PERFORMANCE

Historically, SRI funds have struggled with the perception of lower returns – that negative screening, while ethically appealing, risks missing out on performance. And for most investors, that’s not an acceptable trade-off.  Underpinning this perception for years was a lack of convincing evidence that ESG investing could enhance risk-adjusted returns.

Today, however, our definitions and filters for responsible investing have evolved, as have the approaches to evaluating how “responsible” or “sustainable” an investment might be.

The rise of third-party ratings represent one such approach, with ESG metrics increasingly integrated into every level of financial analysis. Studies from global ratings and indexing agencies, such as MSCI, are providing more proof that ESG factors are financially relevant, and that companies with higher ESG ratings are more profitable and less exposed to the kind of events that can decimate a company’s stock price.

Robust ESG analysis of a company is not limited to climate impact – it also includes human and labour rights, integrity of supply chain, data governance and security, legal and tax compliance, and determining whether the company has established and is following its own ESG framework internally. One MSCI study showed that companies with higher ESG ratings paid higher dividend yields, and another concludes: “Stronger ESG characteristics are linked to better business practices, such as achieving better innovation management, creating long-term business plans, and providing better customer satisfaction.”[3]

Another approach is through thematic research and security selection. Asset managers such as Schroders seek to identify investment opportunities that arise from changes in regulation, public and shareholder pressure, conformity (or not) with increasingly common sustainable practices, and other trends emerging from an undeniable cultural shift. At the heart of this approach lie two investment questions: what companies are at risk, and which are well positioned to benefit?

For example, some themes Schroders has developed include:

  • The physical risks of climate change (oil & gas, utilities, and basic resources companies most at risk)
  • Plastics (bioplastics and waste management companies represent potential investment opportunities)
  • Farm to pharma (sourcing peripheral solutions to antimicrobial resistance)
  • Sustainable fashion (the textile industry is one of world’s biggest polluters, and more consumers are saying they’re willing to pay more for sustainable garments)[4]

Schroders use structured, data-driven proprietary tools that combine research themes with statistics from both conventional data suppliers and more unconventional sources that can provide a more holistic, 360-degree view into a company’s financial wellbeing, social impact, and regulatory compliance (eg, Trustpilot, EnergyStar).

As the scale and scope of ESG have evolved, it’s gained more public and policy support – and made a stronger case for investors seeking robust risk-adjusted performance. Large corporations and individual investors alike are expressing their preferences, calling for more change and reform, and working together to make decisions that can shape the future for all of us.

Stronger ESG characteristics are linked to better business practices, such as achieving better innovation management, creating long-term business plans, and providing better customer satisfaction.

Other articles in this edition

TALKING ESG WITH CLIENTS

With the increasing pressure to include ESG considerations in client discussions, we examine why advisers should be talking to clients about sustainable investing and how to go about it.

ESG-FRIENDLY DEFAULT CONUMDRUM

We’re keenly aware of the implications of ESG for default funds. Here we look at how the industry is grappling with integrating ESG into workplace pension default funds.

FUND MANAGER FOCUS: SCHRODERS

We talk to Andy Simpson, manager of the Scottish Widows Ethical Fund, and Matthew Bennison, manager of the Scottish Widows Environmental Fund, both from Schroders, about their ESG screening process.

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