Exploring the World of ESG Investing: Part I
ESG Investing is a practice where investors analyze and consider a company’s attention to Environmental, Social and Governance issues when choosing where to invest their money.
ESG is considered a non-financial key performance indicator (KPI), meaning it cannot be found on a company’s financial statements and is not a traditional investment strategy. As a result, ESG was no more than a niche trend for those who wanted to invest in a more responsible way -- until now. The importance of considering ESG issues derives from firms’ potential to limit future risk by actively avoiding making a negative environmental, social, or governance impact.
For example, a textile company that chooses not to analyze their emissions from operations may not only be harming the environment, but also incurring unnecessary costs due to inefficient operation, which hurts their bottom line.
As threats of global warming gain momentum, the coronavirus pandemic continues to leave people jobless (unemployment rate is still above 10%), and a new generation of millennial leaders continue climbing up the corporate ladder, concerns covering all aspects of ESG have gained relevance in how companies function. For investors, ESG has provided a more traditional investment motivator: clear market outperformance.1
To determine hierarchy in the ESG world, companies are given ‘ESG Ratings’ by a variety of research firms. Much like a credit rating from Standard & Poor’s, Fitch or Moody’s, ESG ratings are determined based on the many different factors that fall under Environmental, Social or Governance categories.
This diagram provides a few of the subcategories considered when ESG ratings firms assess companies. Image via https://www.ftserussell.com/data/sustainability-and-esg-data/esg-ratings
Some of the top ESG research and rating companies include MSCI, Sustainalytics (recently acquired by MorningStar), ISS, Thomson Reuters and Bloomberg.2 A more comprehensive breakdown of these ESG ratings will be provided later in the series, but can also be found here.3
Investing with ESG considerations has infiltrated nearly every part of the traditional investment market. Whether it is individual ESG company stocks, indexes, ETFs, the fixed income market or other investing mechanisms, investors are commonly considering ESG principles. Among the most popular ESG investment mechanisms are funds, the amount of which skyrocketed in 2019.
Sustainable Funds alone pulled in nearly four times the amount of new money in 2019 as they did in 2018, the year with the previous record for new capital.4 By the start of 2020, there were at least 564 ESG Consideration Funds (which include the Sustainable Funds) managing just under one trillion dollars in assets.5
Over the past few years, investments into assets with strong ESG standards have markedly outperformed investments into assets with weak ESG standards.
On major global indices such as the S&P 500, the S&P 500 ESG Index has outperformed the traditional S&P 500 Index by over 2.5% in the past year, doubling the outperformance of the ESG index over the three-year annualized period.6
As measured outperformance becomes more apparent, investors will begin to gain a better understanding of the value of a company’s ESG rating.
Attention to concepts like the cost-cutting and consumer-appeasing nature of minimizing firms’ carbon footprint, the productivity benefits firms reap from fostering a strong employee culture, and the more representative decisions firms can make with a diverse executive team are all primed to become more relevant in the near future.
Skeptics of ESG’s growth have often cited the record 128-month period of economic expansion in the United States as the primary driver of the index’s performance, adding that the ESG trend would fall flat in an economic downturn.
However, when the United States officially entered a recession due to the coronavirus pandemic, ESG showed its true strength by determining which companies had the ability to weather a crisis. According to MorningStar, Q1 performance of ESG companies have continued to overachieve:
“The returns of 70% of sustainable equity funds ranked in the top halves of their categories and 44% ranked in their category's best quartile. By contrast, only 11% of sustainable equity funds finished in their category's worst quartile. That's 4 times more sustainable funds finishing in the best quartile than in the worst quartile of their categories.”7
Increasing the chance of profitability is the only way to universally get the attention of investors, and ESG investing appears to be in its initial stage of becoming a well-known practice.
ESG ratings have become a proven KPI that measures a company’s resiliency and ability to manage and limit risk. High-scoring ESG funds have recently thrived against the S&P 500 during economic expansion, and in the current chaotic state of the market, investors put their money into ESG funds at an ever higher level in Q1 of 2020.8 The investor sentiment is clear: ESG issues are no longer just a niche trend.
Written by Jason Kauppila
Edited by Pranshu Gupta, Rohan Mehta, Jack Argiro, Gihyen Eom, Calvin Ma & Alexander Fleiss
References:
1. https://openmarkets.cmegroup.com/16235/why-esg-is-outperforming-the-sp-500
2. https://www.sicm.com/docs/who-rates.pdf
3. https://corpgov.law.harvard.edu/2017/07/27/esg-reports-and-ratings-what-they-are-why-they-matter/
4. https://www.cnbc.com/2020/01/14/esg-funds-see-record-inflows-in-2019.html
5. https://www.morningstar.com/articles/973432/the-number-of-funds-considering-esg-explodes-in-2019
6. https://www.spglobal.com/spdji/en/indices/equity/sp-500-esg-index/#overview