Can ESG investing make the jump to the mainstream?

08 Oct 2019

Can ESG investing make the jump to the mainstream?

What will drive environmental, social and governance investing from being the fastest-growing investment approach globally to the one chosen most often?

ESG-based strategies don’t just deliver competitive performance. They also provide valuable insight into areas of material investment risk and opportunity, alongside traditional financial measures, such as cash flow and earnings.

In a 2015 paper, Swiss banking giant UBS concluded that “the business case for ESG investing is empirically very well-founded”.

UBS compiled the findings of 2,200 studies on ESG investing since the 1970s. They found that in 90% of the studies, ESG investing showed no negative performance versus the traditional approach, and many of the studies showed a stable positive performance over time.

In fact, 2018 was the third consecutive year of record flows for sustainable funds, despite unfavorable market conditions, according to Chicago-based financial research firm Morningstar’s 2018 Sustainable Funds U.S. Landscape Report.

Last year, 63% of U.S. sustainable funds were ranked in the top half of their respective Morningstar categories, outperforming regular funds for the second year in a row.

Evidence to the contrary

But the news about ESG investing is not all good. A Pacific Research Institute report reveals that ESG funds do not perform as well as an S&P index fund for a variety of reasons.

First, ESG funds lack diversification and typically possess fewer companies than an S&P index fund. Second, ESG funds have higher expense ratios than an S&P index fund. Finally, ESG funds prove unable to match the S&P index fund in one-year, five-year or 10-year performance periods.

Abhay Laijawala, Managing Director of Mumbai-based Avendus Capital’s new ESG fund, contends that early investors into ESG funds stand to benefit the most. “Once the fund sees a major spike, it will influence other investors to join the bandwagon and we’ll see even more money actively chasing ESG funds.”

The need for standardization

An international standard for measuring the validity of ESG investments – similar to universally-acknowledged global accounting principles – may prove one of the biggest enablers for ESG investing.

Investors and companies need to work together to promote the standardisation of ESG data.

“There has been progress in recommended standard metrics such as the Sustainability Accounting Standards Board framework, which identifies material ESG issues for 77 different industries and recommends a standardized approach to disclosure and metrics,” notes Cotte.

“For investors and companies, it is a great starting point to help identify material ESG issues, understand how they might impact value and how they should be disclosed,” she adds. In India, Shah states that there are talks about creating an ESG Index at the National Stock Exchange, a move that he believes “will create a lighthouse towards which people will gravitate”.

Both Cotte and Shah contend that although ESG-specific indices are useful, it is important for investors to understand how those indices are constructed.

“The ESG characteristics of the index are dependent on the methodology behind the ESG ‘score’ assigned by the ESG research provider.  If companies are simply re-weighted within an index, investors may be surprised to find some companies with controversial ESG practices included in an ESG index.”

ESG is here to stay

One thing is clear: ESG is the fastest growing investment approach globally. As ESG research and data proliferate, offering investors more proof points, ESG uptake will accelerate. This is especially true in light of the increasing relevance that non-financial issues – ranging from climate change, data security, waste management, labor practices, gender diversity, and board independence to name a few – will have on long - term business performance.

For ESG-investing to go mainstream however, there needs to be a major mindset shift, ensuring short-term decisions do not erode long-term objectives.

The constant pressure for funds and companies to meet or beat benchmarks every quarter can impede the growth of sustainable investments. These often require longer time horizons to realize their gains, both in terms of returns and global development goals.

Last year, legendary investor Warren Buffett, along with Chairman and CEO of JPMorgan Chase Jamie Dimon called on companies to stop issuing quarterly earnings guidance. This would provide more flexibility in meeting longer-term goals without getting distracted by the short-term pressures that often warp management decisions. This change could remove one of the biggest hurdles to financing global development goals and may encourage a wave of money to flow towards ESG investments.

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