• Applying ESG data in investing decisions has taken off, sustainable investment showing spectacular growth year over year
• Growth comes from institutional investing mostly but Generation Y will drive green retail investing over the next decade
• Not all assets with an ESG label have the same level of positive impact, depending on the ESG strategy selected by investors

ESG investing becoming mainstream

Now that we better understand how companies benefit from ESG excellence, let’s take a closer look at how investors incorporate ESG factors in their investment decisions.

Not that long ago, investing in green- or socially favorable assets was almost seen as philanthropical rather than economical. Indeed, global assets with an ESG mandate are barely visible in the chart to the right, at the beginning of this century.

From that starting point, it reached a level of $ 40.5 trillion in 2020 and is forecasted to touch the $ 160 trillion bar by 2036. By then, that is expected to be close to 100% of total assets under management!

Mindboggling as those numbers are, it is good to comprehend what kind of assets are considered to have this “ESG mandate”.

Different shades of green

With the increase in popularity of sustainable investing, the risk of improper use of that label rises too. “Greenwashing” can be tempting for companies and fund-managers alike to attract investors under the pretention of providing investment assets that are mindful of ESG performance. Also there are many different shades of mindfulness when looking at investment strategies that include ESG targets, one strategy having (much) more impact than the other.

From the available ESG investment strategies, the three that are most popular (see table below) are:

1. Exclusion of certain sectors, practices or companies from a potential investment list based on certain ESG criteria. Main objectives of this strategy are to influence companies to change their business models, and to mitigate ESG-related portfolio risk. This strategy has a limited, indirect impact as it is difficult to change a company in which you do not own shares.
2. ESG integration incorporates ESG data alongside traditional financial analyses into the investment selection process. Main objectives are mitigation of ESG risk and maximalization of investment returns. This strategy hardly impacts behavior of companies as the focus is on return on investment.
3. Corporate engagement strategy concerns an active engagement of shareholders with a company on a variety of ESG issues, to change company behavior, policies and practices. In terms of impact, this strategy ranks high as it generates a direct influence on matters of ESG.

Investors that are looking to minimize risk and/or maximize profits are served by the first two strategies but should steer away from the third one. Those who are in it to make our world a better place however, will probably go with a corporate engagement strategy. In this context it is important to understand exactly which strategy or strategies a fund is deploying, before investing in it.

Institutional ESG investment

Institutional investment makes up the majority of sustainable investing at large. Although the share of retail in total sustainable investing is slightly increasing, institutional investing still represented three quarters of the total in 2018.

As diverse a group as institutional investors are, a few common drivers can be identified behind their interest in sustainable assets:

• A strong demand from their stakeholders to integrate ESG targets.
• Potential increase of regulation that address ESG concerns.
• Better capability to price ESG risk and thus better understand its financial materiality.

This ESG awareness by institutional investors rose distinctly over the last years. Research by EY under close to 300 institutional investors shows how this group is stepping up their focus on ESG.

Including ESG requirements in institutional investment strategies can be rather complex. Especially when the investment horizon is long (insurance companies, pension funds), the potential risk and reward of incorporating E, S and/or G in the investment mix is difficult to estimate.

On the one hand, applying ESG criteria may reduce the diversification of portfolios, increase risk and thus have a negative impact on returns over the long-term. On the other hand, selecting stock from companies that do well on ESG can have a positive impact on investment returns.

Other complexity comes from the difference in impact of the separate E, S and G factors. A study involving companies listed in Germany for example confirms that the “Governance” factor has the strongest financial impact on performance. One possible explanation can be that the impact of changes to governance are visible more quickly than those from environmental and social changes.

Institutional investment in sustainable assets usually follows these steps (see also OECD’s Business and Finance Outlook 2020):

1. Application of certain exclusion criteria, filtering out certain industries or controversial topics.
2. Selection of potential winners by applying a set of dedicated ESG metrics.
3. Determining best-in-class assets, either by incorporating ESG factors in a fair value calculation or by applying a bespoke ESG analyses methodology.

Throughout this process, investors make use of international norms and standards. They also use ESG rankings, ratings and data that often are provided by external suppliers such as Bloomberg, Morningstar or MSCI. All of which we will discuss in another article.

Retail ESG investment

Retail investors have also started to consider the performance on Environmental, Social and Governance factors of their investment portfolio, since ESG-mindful investments provide returns that are equal to- or higher in comparison to more traditional investments, at a lower risk profile.

As seen earlier, the percentage of retail in total sustainable investment assets is still relatively small around the globe. Good ESG scores seem to be a ‘nice to have’ for this category of investors, as during the COVID-19 hit and subsequent re-bounce of stock markets, fund-inflow of highly rated ESG funds dropped against that of medium- or low rated ESG funds. A trend that is not observed for institutional investments (Döttling and Kim, September 2020).

Having said that, retail investments in sustainable assets is expected to boom over the next decade. This will be driven by the desire of the millennial generation (also called Generation Y) to invest in accordance with their values. Morgan Stanley research concluded that this generation is 2 times more likely to invest in companies with positive social or environmental impacts than other investors. In combination with the expected transfer of wealth to millennials from older generations, that should properly set off sustainable retail investing!

In conclusion

Clearly investors in sustainable assets can have very different objectives to do so, institutional or retail alike. Investing in assets that score well on Environmental, Social and/or Governance matters, can be a way to minimize risk or to maximize returns, depending on the ESG strategy chosen. Also it can be a mean to have direct influence over companies by being an active shareholder, alone or with a group of like-minded investors to try corporate behavior or policies.

In any event, sustainable investing has taken off and will become more and more important over time. That calls for rigorous norms and standards as well as strong and independent rating systems, assurance- and data providers.

Also, what asset classes are we talking about anyway when speaking about sustainable investing applying ESG criteria?

Topics for a next article!