Why ESG Investing Is A Megatrend No Manager Can Ignore.

The following article was originally published in “What I Learned This Week” on June 19, 2019 by 13D Research

Sustainable investing is a nebulous, if not often disingenuous category, yet its skyrocketing growth is no less staggering. In 2018, 290 ESG-oriented open-ended and exchange-traded funds were launched globally. According to a report by the Global Sustainable Investment Alliance, at least $30.7 trillion is now held in sustainable or green investments, up 34% from 2016. “These money flows account for one-third of the tracked assets under management,” according to Bloomberg.

Source: Bloomberg

For years in these pages, we have dissected the implications of consolidation in the investment ecosystem. Wealth has consolidated: the world’s eight richest men now possess as much wealth as the poorest 50% of the global population. Sectors have consolidated: concentration has increased in 75% of U.S. industries since 1996. Asset management has consolidated: the top-10 asset managers now control 34% of global AUM. And investment strategies have consolidated: passive and algorithmic strategies now account for roughly 60% of all trading volume in stocks. These megatrends have influenced investment returns for more than a decade, shaping how and where capital moves.

Now, with funds concentrating in “sustainable” investing products, there may be no megatrend more essential to understand, both for asset managers looking to attract funds or maximize performance. According to a recent study by Morningstar, 72% of all U.S. investors are now “at least moderately interested in sustainable investments.” That number is even higher for younger investors and women. According to internal research by JPMorgan Private Bank, 86% of millennials — a generation set to inherit $30 trillion from their parents over the next 30 years — say that sustainability is an investment priority. And according to UBS, women — who will hold 32% of global wealth by 2020 — are set to invest more than $2.3 trillion for social causes by 2021.

Regardless of the amount of capital already invested, sustainability remains a megatrend in its infancy. Investor interest will escalate as the impact of climate change only grows more severe. Investor confidence will grow as governments from Europe and North America to Asia formalize sustainability standards for investment products and company reporting, a process already underway. And the fiduciary responsibility of asset managers to employ ESG as an investment factor will only increase as environmentally-and-socially responsible companies increasingly outperform in the decades to come.

Sustainability will determine where the passive herd concentrates capital. It will emerge a key factor for algorithmically-determined market moves. And it will influence the stability of companies as low-sustainability scores lead to public and investor backlashes and management shake-ups. These dynamics are already manifesting and as the revolution increases in power, sustainability will not only be an ethical choice, but an investment imperative.

There’s no de facto definition of a sustainable investment. The causes vary, from climate change to public health, managerial ethics, and even religion. “Greenwashing” is no doubt rampant — “sustainability” as a marketing tool for perfunctory, if not altogether unsustainable investment practices. Investment products branded as “environmentally friendly” commonly include fossil fuel companies. After Facebook and Wells Fargo were dropped in April, the S&P 500 ESG Index now includes 316 firms — a number that hardly suggests strict standards for what qualifies as environmentally and socially responsible.

Writing last month for Harvard Business Review, Saïd Business School visiting professor Robert Eccles encapsulates the seven common strategies used today:

Source: Harvard Business Review

Since the socially-responsible investing (SRI) movement of the 1980s, sustainable investing has been largely portrayed as an ethical sacrifice — a path that will inevitably compromise returns. Looking at the performance of ESG ETFs and this depiction does not appear inaccurate. The iShares MSCI KLD 400 Social ETF has had 14.48% returns over 10 years versus 15.32% for the S&P 500. The iShares MSCI USA ESG Select ETF has had a 10-year return of 14.12%. Even the S&P 500 ESG Index has underperformed the S&P 500: five-year annualized returns of 10.8% versus 10.9% for the index as a whole.

However, digging deeper, this underperformance appears more a byproduct of how the indexes are assembled. If ESG factors are measured more precisely and applied more discriminately, they can be a predictor of corporate success, and in turn, equity performance. Eccles recaps some key studies that have confirmed this relationship:

“A [2014] study by Harvard Business School’s George Serafeim and colleagues…found that companies that developed organizational processes to measure, manage, and communicate performance on ESG issues in the early 1990s outperformed a carefully matched control group over the next 18 years…A 2017 study by Nordea Equity Research (the largest financial services group in the Nordic region) reported that from 2012 to 2015, the companies with the highest ESG ratings outperformed the lowest-rated firms by as much as 40%. In 2018, Bank of America Merrill Lynch found that firms with a better ESG record than their peers produced higher three-year returns, were more likely to become high-quality stocks, were less likely to have large price declines, and were less likely to go bankrupt.”

As climate change intensifies, the outperformance of environmentally-and-socially responsible companies will only increase. We’re already seeing this manifest. As the Wall Street Journal reported this week12 clean-energy ETFs tracked by ETF Database were up 21.2% on average this year through June 5th, which compares to a 13% gain for the S&P. And then there’s Beyond Meat’s 600% surge since IPO, a move no doubt as much driven by the company’s potential in mitigating climate change as the taste of its product. While we believe Beyond Meat’s stock has tipped to euphoria, investor optimism is not unfounded: sustainability is more and more a key factor in consumer decision making. As Nielsen found in a recent study, 66% of all global consumers and 73% of millennial consumers are willing to pay more for a sustainable brand.

Of course, measuring firm-by-firm environmental and social responsibility is difficult, if not impossible in many cases. How do you rank companies based on ESG factors if they don’t report on material sustainability issues like carbon footprint, worker wages, or product safety? A cottage industry of ESG ratings agencies has sprouted up. Many funds do their own firm-by-firm ESG due diligence. And companies are beginning to be more transparent: according to the Associated Press86% of S&P 500 firms published sustainability reports in 2018.

However, until ESG reporting standards are ubiquitous and obligatory, ESG investing will always be part science, part guesswork. Governments are now taking action to mitigate this problem, especially in Europe. According to a Financial Times report from May, European lawmakers are “close to agreeing to the details of a Europe-wide classification system that will define what qualifies as an environmentally ‘sustainable’ investment.”We expect U.S. regulators to follow suit sooner than later: the more money that pours into ESG strategies, the more the investing community will demand standards.

Asia will also close the gap with the rest of the world in terms of sustainable investing. Minus Japan, estimates suggest only 0.8% of total AUM in Asia is managed by sustainability strategies. Meanwhile, huge institutions are facing escalating pressure to make sustainability a priority, from sovereign wealth funds and pension funds to university and museum endowments. For one marquee sign of the times, Norway — a nation that has thrived on petroleum extraction — announced this year it will pull a significant portion of its oil and gas holdings from its $1.1 trillion sovereign wealth fund’s portfolio (see WILTW March 14, 2019). If predicting investment returns means predicting where capital will concentrate, no megatrend will prove more important to portfolio performance over the next decade than ESG.