The concepts of corporate social responsibility, environmental consciousness, and accountable corporate governance have been gaining prominence in the modern business environment. They became the elements of a single approach commonly referred to as “sustainable growth”, which became highly relevant amongst investors seeking sufficient returns on investments and tolerable levels of risks. In this context, ESG (Environmental, Social, and Governance) investing emerged as a response to the growing demand for sustainable investment strategies. In this article, we will provide an overview of ESG investing and hopefully help you make investment choices in line with your values.
ESG investing focuses on three underlying factors, namely environmental, social, and governance, which opts in companies that are making positive impacts in the three areas highlighted in Chart A. Investors are increasingly applying these metrics as part of their analysis process to identify and minimize related risks, while achieving financial returns and long-term positive effects on the environment, society, and business entities. The range of the indicators reflects the focal points affecting the performance of the companies over time. This approach supports active and passive investing strategies based on their respective instruments.
SRI vs. ESG: What's the Difference?
When constructing a timeline, we’ll note that Socially Responsible Investing (SRI) appeared in the 1970s seeking prevention of investing in socially irresponsible businesses, such as tobacco, and prioritizing socially responsible ones such as agriculture. The concept involved in ESG investing went beyond the industry analysis into the assessment of companies and their specific practices based on the three elements of the approach.
Chart A (Source: CFA Institute)
ESG Investing Seeks Positive Financial and Social Returns
The appeal of ESG investing stems from the ability to have a positive social impact in addition to financial gains. While this is a predominantly behavioral factor, it also translates into the long-term performance of ESG investments. Specifically, the companies seeking sustainable growth are expected to be more resilient to economic shocks and demonstrate consistency in their outcomes. The support of local communities and additional efforts taken to assume leadership roles in their respective societies generate goodwill towards sustainable corporations. Thus, companies are able to utilize this additional capital for attracting and retaining valuable human resources, as well as achieving inherently higher financial results. The recent downturn due to the novel pandemic serves as a good example. According to Morningstar, 51 of its 57 ESG-screened indices outperformed their broad market equivalents in the first quarter this year (Lefkovitz).
The analysis of ESG investing has shown its importance for investors and the business environment in general due to its ability to promote sustainable business practices through capital allocation. It also relies on the assumption that sustainable businesses are able to outperform their peers in the long term. The trailing return history for ESG and Non-ESG portfolios demonstrates that ESG funds have the potential to achieve higher return than non-ESG funds in recent years, with the increasing social awareness of ESG issues as well as availability of funds with an ESG focus.
Potential Diversification Risks
While ESG investing offers a broad range of benefits, similar to any other type of investment strategy, it also carries certain risks and respective drawbacks. In particular, certain funds are excluding entire industries; e.g. pharmaceutical, in order to be in line with the SRI principles, which could be largely subjective. In addition, ESG investing focuses primarily on the large-capitalization corporations, limiting the diversification potential through the inclusion of the small and mid-size companies. This occurrence stems primarily from the higher level of transparency and consistency in reporting by larger companies. The two Morningstar equity style boxes below illustrate a balanced asset allocation for ESG and Non-ESG portfolios. The non-ESG portfolio is more diversified across the equity styles compared with the ESG portfolio.
The Number of Funds Considering ESG Exploded and ESG Rating System Launched
With the growing popularity of ESG investing, the total number of exchange-traded funds with an ESG focus reached 300 in 2020 (Iacurci). At the same time, the number of funds that added ESG criteria to their prospectus reached 500 in 2019 (Hale). In order to supply investors with sustainability-focused analytics, Morningstar, Inc. reached an agreement to acquire Sustainalytics which focuses specifically on ESG research and ratings. The ratings of the Morningstar Sustainalytics use historical-based calculations with a score between 0 and 9.99, showing negligible ESG risk and a score above 40 implying a severe level of risk. The ratings and scores reflecting the levels of sustainability are essential for the broad higher quality of analysis potentially addressing the existing risks of ESG investing.
If you would like to learn more about ESG investing or have a passion to invest for good, please contact Portfolio Manager Jenny Wang and Senior Financial Analyst Yunen Ding via our contact form.
Written By: Portfolio Manager Jenny (Zhen) Wang, CFP® , CFA® and Senior Financial Analyst Yunen Ding
- Hale, Jon. "The Number of Funds Considering ESG Explodes in 2019". Morningstar, Inc., 30 March 2020, www.morningstar.com/articles/973432/the-number-of-funds-considering-esg-explodes-in-2019
- Iacurci, Greg. "Money moving into environmental funds shatters previous record". Morningstar, Inc., 14 January 2020, www.cnbc.com/2020/01/14/esg-funds-see-record-inflows-in-2019.html
- Lefkovitz, Dan. “How Did ESG Indexes Fare During the First Quarter Sell-off?” Morningstar, Inc., 8 Apr. 2020, www.morningstar.com/insights/2020/04/06/how-did-esg-indexes-fare?utm_source=eloqu