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Rise and rise of the socially-conscious investor
INVESTORS and companies are becoming increasingly aware of their environmental, social and governance (ESG) footprint. This often starts with something as simple as promoting energy efficiency or avoiding disasters like oil spills, but is often much more sophisticated, such as focusing on positive community contributions or avoiding corporate scandals.
As an investor, there is rising evidence that allocating at least a part of one's investments using strategies that incorporate ESG can have numerous benefits, regardless of whether one's goal is improving the 'impact' profile of an investment allocation or simply ending up with a better investment outcome.
What is ESG investing?
ESG investing involves applying a set of agreed criteria to select companies on the basis of corporate sustainability. Examples of common criteria include those agreed at the UN Global Compact, the UN Principles for Responsible Investing (PRI) and the Sustainability Accounting and Standards Board.
'Sustainability' as an investment approach is now a well-researched approach to investing, with one study arguing that more than 20 per cent of global assets are now managed in a 'sustainable and responsible' way.
Moreover, awareness of ESG issues has grown considerably over time, as evidenced by the rising use of ESG data. The trend is not just a phenomenon for institutional investors alone - a recent study found that almost 60 per cent of ultra-high net worth families considered impact investing as a distinct asset class.
But there is clearly room for investor awareness to rise further. A bank-commissioned survey on sustainable investing trends noted that a 'lack of information' was the main barrier against adding more investments in ESG strategies, while the perception of lower returns vs regular investment strategies (a view we disagree with later in this piece) appears to be a second hurdle.
The reasons for adopting a 'sustainable' investment approach can vary, and this may not be performance-oriented alone. Some investors may see ESG as a way to simply enhance investment returns. Others may see this as an investment approach that is consistent with their values or beliefs where a simple risk-return framework may not be always applicable.
For example, an investor may choose to avoid investments in alcohol, tobacco or gambling as they may find these socially objectionable.
We see ESG as a strategy that can help achieve three goals: potentially outperform the broader market in select situations, reduce volatility of investment allocations, and ensure more socially-responsible investing for a given investment allocation.
So how does it work?
When it comes to applying ESG to an investment strategy, there are many approaches. Initial efforts tended to concentrate on an 'exclusionary' approach, which screen the investible universe with these criteria before applying any other investment decision-making processes to this reduced universe, often at an industry level. The main downside of this approach is blindly screening out potentially strong sources of investment performance.
More nuanced approaches, instead, incorporate ESG as an additional factor within a broader investment decision-making process, or involve actively working with companies to improve their sustainability scores.
The good news is that there is wide agreement that ESG investing does not come at the cost of inferior investment returns. This means that investors who want to ensure their financial investments also have a positive sustainability impact are able to achieve this goal via ESG strategies without sacrificing investment returns.
ESG investing may actually end up helping investors build a better investment allocation. There is much evidence that incorporation of sustainability factors leads to improved risk management.
Studies suggest ESG-compliant firms face lower costs of capital and a low risk premium due to greater transparency. Such firms tend to face a lower risk of their assets becoming 'stranded assets' or worthless.
For an ESG-focussed investor, this means that even if returns with and without ESG factors are similar, the same return may be obtained by taking less risk. This point is illustrated in the chart, where we show that investment allocations that include a small allocation to ESG equities offer better returns for the level of risk taken in most cases.
The evidence on whether an ESG-based investment strategy leads to outperformance relative to a global equities benchmark is mixed. While a majority of studies argue there is a reasonably high chance that adding ESG criteria can lead to better investment returns over time, this is often sensitive to whether the ESG criteria are used to simply screen out investments that do not meet the conditions, or whether they are used as an additional factor as part of a broader investment process.
Where the evidence appears more compelling is that incorporating 'sustainability' as a criterion appears to support improved corporate performance in specific parts of the market, such as bonds, real estate and emerging market equities.
ESG investing does not come without its own risks. One critique comes from studies that show that active exclusion of 'sin' sectors (such as alcohol and tobacco) can detract from performance over time. A greater share of the market trying to meet the ESG criteria means it will mathematically become harder and harder for the approach to outperform. Nevertheless, on balance, we believe the positive characteristics of ESG investing outweigh the risks, causing us to take a constructive view on incorporating ESG into one's investment strategy.
- The writer is head of Fixed Income, Currency and Commodity Strategy at Standard Chartered Private Bank.