ESG and Investing – No Longer a Choice

Environmental, Social, and Governance (ESG) factors have been incorporated in investment decision-making for decades. What began as an effort by the Methodist Church to encourage its members to avoid “sin” stocks in the 1800s is becoming mainstream.

Green Investing Boom

While many will be aware of companies like Tesla and the seven-fold increase in the value of its shares in the last two years, the broad strength of companies perceived to be climate-friendly may not have been as buzz-worthy. When The Economist assembled a portfolio of public companies that stood to benefit from the energy transition and looked at how they had performed since January 2020, it found that the value of this portfolio had increased at twice the pace of the US equity market. [1]

Terminology

The vernacular of this space can be confusing. Rather than delving into this here, this short video [2] walks through some of the basic definitions.

We like the following definition of ESG integration: “The analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance (ESG) factors.” [3]

Who’s Paying Attention to ESG?

It used to be that some “hard-core” investors thought of environmental or social factors as rather fluffy. Less so with governance issues, though these were often viewed through a lighter lens than today.

I recall sitting in industry meetings on the topic over a decade ago and listening to institutional investors debate whether or not they were failing their fiduciary obligations to their clients if they incorporated environmental or social factors in their investment decision-making. Their job was to make money, they would say – the government and the regulators should sort the E, S, & G stuff.

It’s truly amazing how much this has shifted. These days, most serious investors are integrating ESG in their investment decision-making processes. CPP Investments, Ontario Teachers’ Pension Plan, and many other pension investors are on board. The University of Toronto and many other University endowments (Harvard and Yale too) are there – as are Canada Life, Sun Life, Blackrock, etc. Not exactly a fluffy group.

In a recent session that Prime Quadrant organized with investment manager RPIA to discuss ESG investin, one of the remarks was that ignoring ESG factors today would feel like a dereliction of fiduciary duty.

What We Hear From Families

The majority of families we serve at Prime Quadrant feels that incorporating ESG factors in the investment decision-making process is important. These families often emphasize their belief in the importance of strong corporate governance, in particular (not surprising from such an accomplished group of people).

There are, however, families that do not yet share this view. And while the conversation is just beginning with some of these families, it seems they may be thinking about the issue similarly to those institutional investors of a decade ago – i.e., investing is about making money and not about making calls on broader societal issues. We look forward to continuing the discussion – and hope this article contributes to it.

Prime Quadrant’s ESG Beliefs

For years Prime Quadrant and others have felt that companies that are progressive from an E, S, and G perspective are also likely to be advanced in other parts of their business – leading to better results. Our view has been that ESG strength is likely to be indicative of strong and forward-looking management.

Combining this view with the current importance and urgency of many E, S, & G issues in the world leads us to believe that these factors cannot be ignored when making investment decisions. Designing and managing investment portfolios is primarily a risk management exercise. Ignoring E, S, or G risks feels like a significant miss for investors – regardless of one’s investment objectives. Put another way, “ESG” should not be viewed as some separate activity or strategy that investors can choose. Instead, it should be considered one of the many necessary components of thorough investment analysis.

Some say that incorporating ESG factors in investment decisions is too complicated or that the data to do so correctly either does not exist or is inconsistent. As discussed during the ESG event with RPIA, this is not a problem – instead, it is an opportunity. Thorough and thoughtful investment analysis will always be hard, and there are shades of grey throughout the process. If investment or ESG-related data were precise and uniform, the research would undoubtedly be easy – though the opportunities for solid analysis to lead to better outcomes would be fewer.

Our view and others’ is that ESG integration in investment decision-making is in its infancy – and thoughtful investors that dig in now are more likely to identify opportunities.

ESG and Investment Performance

So what does the data say? Does an ESG integration approach to investing work?

So far, so good. Here are a few key findings from a recent “study of the studies” (one thousand plus of them!) on the topic: [4]

• ESG integration was positively linked to corporate financial and investment performance approximately 60% of the time (neutral approximately 35% of the time, and negative only about 5% of the time).
• Improved financial performance due to ESG becomes more marked over longer time horizons.
• ESG investing appears to provide downside protection, especially during crises.
• Sustainability initiatives appear to drive better financial performance due to improved risk management and more innovation.
• Managing for a low carbon future improves financial performance.

As discussed during the Prime Quadrant conversation with RPIA, there is no question that renewable energy, electric cars, and other climate-friendly businesses are attracting premium valuations.

The “chicken and egg” question here is whether the outperformance results from ESG factors alone - or is it due to a high level of investor interest and, therefore, lots of investment dollars chasing limited opportunities?

While these questions are largely rhetorical, we suspect the answers are “yes” and “yes.” While there is a relatively short list of well-run businesses in this space (which supports the demand argument), it also seems clear that consumer and regulatory pressure on companies to up their E, S, & G performance will only increase.

So again, it feels like we’ve come a long way from the days when the conversation was focused on whether investing in a pro-ESG manner comes with a cost. As RPIA asserted in our discussion on the topic, if you are looking for the best returns and are ignoring ESG, you are missing out on factors that drive both valuation and risk – regardless of your investment objectives.

ESG and the Fully Diversified Portfolio

As you might imagine, incorporating ESG factors in investment decisions is easier in some asset classes than in others, so building a fully diversified portfolio with ESG integration throughout can be challenging.

Mercer, a consultant, evaluates more than 4,400 investment manager strategies on their integration of ESG factors. At present, Real Assets (Infrastructure, Natural Resources and Real Estate) has the highest percentage of managers earning Mercer’s highest ESG ratings and Hedge Funds the least. Equities (Active, Passive, and Private) are second best, followed by Fixed Income and Private Debt. [5]

It is not surprising that Hedge Funds have the lowest ESG ratings given their nature. Many of these diversifying strategies tend to be more trading- and arbitrage-focused than traditional strategies  (which may involve less fundamental or qualitative analysis), making ESG integration more difficult.

Given the diversifying benefits that certain hedged strategies can bring to a portfolio, some flexibility in portfolio construction may be necessary when deciding how and where ESG factors are integrated.

The Future

At the time of writing, the United Nations Intergovernmental Panel on Climate Change had just issued its latest report. The report states that “…the role of human influence on the climate system is undisputed” and that “…human actions still have the potential to determine the future course of climate.” [6] Understandably, the gravity of the report’s findings is front-page news globally.

It seems clear that investors who choose to ignore the environmental impacts of their investment decisions do so at their peril – whether from a risk or return perspective. And while seemingly less acute at a time of such dire headlines regarding our climate, the same goes for the importance of social and governance issues.

It is worth repeating that ESG integration in investment decision-making is in its infancy. [7]

There is a lot of progress to be made in each of the E, S, & G domains, and linking these factors to financial markets and financial decisions can be far more impactful than a purely regulatory approach. We have seen the positive impact that thoughtful ESG integration can have on an investment portfolio – and believe this will continue in the foreseeable future. ESG integration has come a long way – from avoiding sin stocks towards becoming table stakes.