As the world grapples with major social, economic, and political issues, ESG has become the ubiquitous acronym under which investors, financial institutions, corporations, and public policy entities develop guidelines and procedures to address these challenges.
ESG encompasses climate change, global health crises, poverty, diversity, business ethics and many other issues. The complexity of these issues, and the differing perspectives of multiple constituencies, requires investment managers to be thoughtful and balanced in refocusing their investment processes and decisions.
As with any sound investment approach, it also requires flexibility, openness, and a commitment to continually incorporate new information and analysis in making long-term investment decisions.
There is no single best approach in addressing the challenges discussed above. ESG investing approaches cover a broad spectrum, with stringent exclusionary policies or negative screening at one end of the spectrum and proactive, targeted impact investing on the other.
In between these two extremes is a wide range of approaches to integrating ESG investing policies and strategies including hybrid approaches which seek to balance exclusions with ESG optimization in managing investment portfolios. Whatever approach to ESG investing a firm undertakes, it must continue to manage client assets in compliance with applicable regulations.
Investor interest in ESG has been rising rapidly, with annual inflows into ESG-oriented funds climbing from $5 billion in 2018, to $21 billion in 2019, to $51 billion in 2020, to $70 billion in 2021i. At the end of 2021, ESG-oriented funds held $357 billion in total assets, which represented a one-year increase of 27%, bolstered both by the rising influx of new investment dollars and by strong market performance.
That growing interest has incentivized mutual fund companies to launch new ESG-related funds or repurpose existing funds at a rapid pace. A record 121 ESG-oriented funds were launched in 2021 – an increase of nearly 60% over the previous annual record of 76 in 2020 – to bring the total to 534 funds at the end of 2021, according to Morningstar ii.
Breaking down ESG
ESG stands for “environmental, social and governance,” but how do these elements play into corporate policies and procedures?
Environmental
The environmental aspect takes into account both the positive and negative environmental impact of a company’s operation. A company may have lower environmental risk if it has sound policies and measurable actions regarding climate change, greenhouse gas emissions, water conservation, renewable energy, waste disposal, green products and technology, and environmental benefits for its employees. But a company with products or policies that are detrimental to the environment would likely exhibit higher risk in this category.
Social
The social component relates to issues such as company culture and treatment and training of employees, hiring practices, diversity and inclusion, and relationships with customers, consumers, and suppliers. This is one of the more difficult areas to measure, yet it can be impactful to the business. Often, investors consider metrics such as employee turnover or number and frequency of lawsuits alongside policies, procedures, and other qualitative information to gauge how well a company is doing in this category.
(Corporate) governance
Governance involves areas such as executive compensation, policies and diversity of the board of directors, company oversight, and shareholder relations. This area has long been under evaluation for active managers as investors seek to invest in companies with good governance and shareholder protections.
“Greenwashing” brings added scrutiny
With the rising interest in ESG has come increased scrutiny over the investment management industry’s ESG processes, research commitment, and, ultimately, portfolio construction. One aspect of this scrutiny is to ensure that investment management firms or mutual funds that purport to offer ESG strategies are true to that objective, and not just using ESG as a marketing tactic to increase assets under management – otherwise known as “greenwashing.”
Industry regulators, including the SEC, have been active in issuing statements, observations and now rule proposals related to ESG processes and disclosures.
In May 2022, the SEC issued two rule proposals aimed at investment products. The first proposes disclosure requirements for funds and advisers related to the incorporation of ESG factors and analysis into investment processes, and the second proposes updates to the so-called “Names Rule” that include requirements for funds that have “ESG” and other related descriptors in their name. The final rules are still pending.
Are there investment benefits to ESG?
While ESG has taken root due, in part, to changing industry dynamics, its emergence has also contributed to those changing dynamics. This suggests that there may be opportunities for alpha generation when investing through an ESG lens.
For example, firms that address issues like climate change may be disrupting entire industries, such as transportation. Consider the growth of electric vehicles as a case in point. This growth may encourage asset managers to evaluate the impact of electric vehicles on the entire value chain in search of opportunities. Companies in virtually any industry may also employ capital to fund projects addressing ESG issues material to their business, which could create long-term value for shareholders and other stakeholders.
Incorporating ESG analysis is another dimension of risk management utilized while pursuing the optimization of client returns. It is this “middle ground” of ESG risk management where many large financial institutions, including Thrivent Asset Management, have begun to direct their focus.
