Environmental, Social, and Governance (ESG) made a major advance in 2021, with record inflows and expanding choices for investors. Company disclosures, ESG ratings and the regulatory landscape are all evolving to meet growing demand from existing and new investors who want to align interests in ESG with investment strategies. Tornado outlines the key issues — and how to understand them — here.
ESG investing may be a relatively new term, but the concept of investing in assets that match an investor’s values is not. It’s sometimes referred to as socially responsible investing or sustainable investing. Past examples include avoiding investments related to problematic products like tobacco or those related to unsavory connections, such as to South Africa’s former apartheid regime.
Today, a lot of that falls under the ESG umbrella.
ESG Components
ESG investing means considering more than the traditional financial metrics of a company, mutual fund, exchange-traded fund (ETF), or private fund before you invest. It involves weighing the financials with non-financial risks and opportunities the investment may present.
Among the considerations:
- Environmental challenges, such as climate change, natural resource erosion, pollution, and waste;
- Social issues, which range from product liability, human rights, stakeholder opposition, labor relations, and diversity, equity, and inclusion (DEI); and
- Governance concerns, related to corporate behavior or issues involving a board of directors and / or executive compensation.
ESG Trends
MSCI identifies three primary reasons behind the growth in ESG popularity: global sustainability challenges like climate change and demographic swings; a new generation of investors who are highly focused on these changes and want investment products to express their interests; and, as important, more readily available data that, in MSCI’s view, “helps minimize reliance on voluntary disclosure from companies” about their ESG stance.
Today, investors interested in ESG have more options than ever. According to a US SIF Foundation recent biennial report, 836 registered investment companies had ESG-focused assets in 2020, totaling assets under management of $3.1 trillion. This included 718 mutual funds and 94 ETFs. In addition, there were 905 ESG-related alternative investment funds equaling another $716 billion.
ESG has become so popular among investors that, “sustainable funds in the United States attracted an all-time record level of fund flows in the first quarter of 2021,” according to Morningstar. While inflows ebbed a bit from those levels in 3q21, it reported that global sustainable fund assets still amounted to $3.9 trillion distributed among 7,459 ESG funds around the world.
Regulatory Concerns
As investor demand and choices for ESG increase, a lack of standardized ESG definitions prompted the the Securities and Exchange Commission (SEC) to make monitoring fund marketing one of its 2021 priorities.
The SEC’s overall goal is truth in advertising, and the agency has noted in risk alerts that it’s found “some instances of potentially misleading statements regarding ESG investing processes and representations regarding global ESG frameworks.”
Company Sustainability Reports
One way investors can try to size up a company’s ESG efforts is by reviewing its sustainability report. If one has been published, it’s typically located on the company’s website. According to PWC’s Sustainability Reporting, effective reports include the following:
- The context of sustainability related to the company’s business and market;
- A clearly defined sustainability strategy and key performance indicators to measure it;
- An outline of risks and opportunities arising from the strategy and its impact on the bottom line; and
- An explanation of goal setting and incentives for meeting those goals.
Another option is to review ESG ratings put out by various rating agencies and resources. There are myriad options to invest in ESG, from individual stocks to broad and thematic ETFs.
Performance
Incorporating ESG into an investment strategy may be good for more than the environment. While the category is still evolving, large ESG funds have outperformed the S&P over three and five year time frames.
For example, from 2017 through 2021, ESGU, which has over $25 billion in net assets to start 2022, increased 119.6% vs the S&P 500’s gain of 111.9%. From its inception in 3q18 through 2021, ESGV, which manages over $6 billion in net assets to start 2022, increased 74.1% vs the S&P’s gain of 62.6%.
The near term performance is more mixed, perhaps reflecting a heavy weighting to technology. In 2020, for example, Morgan Stanley reported that many sustainable funds outperformed their traditional peers. For the full year of 2021, however, ESGU and ESGV both slightly underperformed the S&P 500 as technology stocks came under pressure.
Originally published on Tornado.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.