-Tony Davidow, CIMA®, President & Founder T.Davidow Consulting, LLC
According to Morningstar, flows into sustainable funds totaled $21.4 billion in 2019, more than a quadruple increase from the previous annual record of net flows.
As of December 31, 2019, there were 564 sustainable funds with $933 billion in AUM that were incorporating some form of ESG screening. With their strong performance during the global pandemic, and the increased focus on ESG investing, all indications are that these strategies will continue to become mainstream solutions.
It is also worth noting that several hedge funds are beginning to incorporate some form of ESG screening, and private equity firms such as Blackstone, Apollo and KKR have announced plans to launch impact investing funds. Sustainable investing has been adopted broadly throughout Europe for many years, and by large families and institutional investors in America.
Several studies have noted the strong demand for education by investors. Therefore, it is incumbent upon the advisor to become better versed on the nuances across the various strategies – ESG, SRI, Sustainable and Impact investing – and the available investing options. There are substantive differences between SRI (negative screening), ESG (relative screening) and Impact investing (effecting change). They all fit under the umbrella description sustainable investing. Advisors will need to help investors in navigating through the various types of strategies and identifying the most appropriate solution(s).
Evaluating ESG Pillars
In my previous blog, Understanding and Embracing ESG, I reviewed the various strategies and some research on the underlying portfolio characteristics. Based on research conducted by MSCI, companies with high ESG scores often have better risk control measures and consequentially exhibit lower tail risk. They generally exhibit higher profitability and higher dividends; and because of their low systematic risk, they typically have a lower cost of capital and higher valuation, which often led to strong sustainable growth.
When considering ESG investing, advisors often focus much of their attention on the Environment, and do not always consider the merits of the Social and Governance pillars. Individually, each helps in identifying good companies with sound policies and practices. Collectively, asset manager and index providers combine the E, S & G in a portfolio. The weighting across pillars may be dependent upon the materiality of each industry or may be optimized to provide a particular outcome.
Environmental screening identifies companies focused on issues such as climate change, energy consumption, the use of natural resources, and reducing their carbon footprint among other issues. These companies typically have in place policies for dealing with the environment, consuming energy and disposing of waste.
Social screening identifies companies with strong employee engagement, good human rights track record, broad employee diversity and fair labor practices. These companies recognize the value of diversity, and the need to embrace employee differences. They proactively promote minorities, often encourage mentoring and engage their communities.
Governance screening identifies companies with independent and diverse boards, fair compensation practices and strong checks and balances. They encourage independent points-of-view and a strong board of directors. They typically avoid reputational risks due to their disciplined risk management.Again, these are independent pillars. A company may have a high E score and a low S score, or a high G and low E score. You may have a company with a diverse board and strong social policies, but they produce fossil fuels; or you could have a company that hires and promotes minorities but lacks diversity on their board. A company that scores well across Environmental, Social and Governance exhibits strong social policies and procedures, a track record in caring for the environment and good corporate governance.
It is also important to consider how these pillars are weighted and incorporated. Much like traditional indexing, there can be dramatic differences between equal weighting the pillars, market-cap weighting or using some form of optimization. The combination of pillars produces a diversified portfolio of companies.
MSCI deconstructed the performance of ESG ratings1, and found that the top quintile ESG companies outperformed the overall market from December 2006-December 2019. Their research showed that the E, S and G all outperformed the market, and the equal-weighted ESG dramatically outperformed the individual pillars. They also analyzed the return versus risk results by regions – World, North America, Europe and Pacific. The ESG results exceeded the individual pillars across all regions. In other words, the sum of the parts exceeded the individual constituents.
Putting ESG into Practice
It is important to note that there are substantive differences between the universe and screening methodologies used by MSCI, FTSE Russell, Refinitiv and Sustainalytics among others. Asset Managers may develop their own methodology for screening and weighting securities.
Based on the information in this blog, advisors should incorporate a checklist that address the following:
- What is the underlying universe of eligible securities?
- What is the screening and weighting methodology used?
- What is the weighting across pillars?
- What has been the historical performance (return & risk)?
- What is the experience of the portfolio management team (for active managers)?
ESG presents an opportunity for advisors to demonstrate their value as an educator and knowledgeable source of information. Investors are seeking help in understanding these strategies, and better aligning their values and portfolios.
1 Giese, Nagy & Lee, “Deconstructing ESG Rating Performance”, June 2020