Return to social values with ESG Investing
- Thu 01 April 2021
Meaghan Victor, State Street Global Advisors
Environmental Social and Governance (ESG) investing is usually in the spotlight during extreme events like the global pandemic or climatic events, such as bushfires and floods.
The COVID-19 pandemic has exposed some very real health, social, financial and political inequities worldwide. Focusing on these struggles and injustices has provided us with an opportunity to gain greater clarity about the values that are most important to each of us and our families.
However, the trend line is unmistakable: ESG investing has been growing for a while. Between 2017 and 2019, ESG investing grew by more than a third, to more than $30 trillion, over a quarter of the world’s professionally managed assets.1 Some estimates say it could reach $50 trillion over the next two decades.2
But exactly what is ESG investing? Some think it is all about investing for impact. Others think it is about imposing a certain set of values on companies.
ESG investing is about informing better decision-making by adding the assessment of material environmental, social and governance issues into the investment process. It enriches traditional research such as analysing financial statements, industry trends and company growth strategies.
Benefits of ESG investing
ESG investing comes with several benefits, the main one being the feel-good factor. ESG investments may be helping the environment and building a better future for the next generation or tackling crucial social issues and encouraging a more diverse and inclusive workplace.
As a result, more investors have made the choice to switch to ESG investing – and they have been met with a flood of ESG funds.
Although choice can at times be a good thing, wide-ranging ESG definitions, debates about terminology and data – and data quality in particular – and an explosion in investment selections have created more confusion than conviction.
The emergence of ESG indices and ESG Exchange Traded Funds (ETFs) has made it easier for ESG-focused investors to reposition their core holdings. But before deciding which ETF to invest in, investors should look under the hood – what is the underlying index, what is the total cost of ownership and does it align with my investment values?
Pandemic highlight’s ESG’s lower-profile “S” Pillar
Historically, the ‘E’ in ESG has taken the spotlight, with vital emphasis on mitigating climate change through corporate and investor action. The climate story was not forgotten in 2020, and indeed many people revelled in the fact that lockdowns caused emissions to fall.
However, the challenges that COVID-19 inflicted on workforces and underprivileged parts of the population made corporate social responsibilities more relevant, increasing the focus on the ‘S’ in ESG and new means of measuring it.
In the United States, while President Biden has rejoined the global effort to curb climate change, it is too early to gauge the administration’s impact on social issues. However, the inclusion demonstrated by Biden’s cabinet picks sends a reinforcing message on the importance of diversity.
Inflection Point
Although the ESG tide has been rising for decades, we believe ESG investing has now reached a critical inflection point. Investors’ lingering reservations about ESG investments seem to have eased and they are increasingly ready to take a stand with their investment choices.
We believe it is time for ESG investing to move from a check-the-box component of investment portfolios to a must-have ingredient in portfolios.
That’s why last year we launched the SPDR® S&P®/ASX 200 ESG Fund (ASX: E200). This was the first ETF to track the S&P/ASX 200 ESG Index, a broad-based, market-cap-weighted index designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P/ASX 200 Index.
This means for the first time, investors will be able to access improved ESG exposure with a similar risk-return profile to the Australian equity market benchmark, the S&P/ASX 200 Index.
Conor O’Daly, Pengana
MSCI defines ESG investing as ‘the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process’.
ESG considerations are important because they address consumer concerns associated with environmental, social and governance matters.
Warren Buffett explains that ‘a share is not simply a ticker creating a squiggly share price chart but is rather ownership of a business’. Everyone has varying thresholds for what types of business they are comfortable owning. ESG funds make it possible for investors to express their ESG thresholds as part owners of a business.
ESG funds provide a platform for society to vote with their pocketbook on acceptable corporate behaviour. By investing in ESG funds, individuals are making their preferences known and as those funds grow, they develop their own influence to counter the special interest groups.
Growth in ESG funds lowers the cost of capital for endeavors that are ESG-compliant and increases the cost of the capital for those that aren’t. This supports the growth of the former while being a growth constraint for the rest. Through this mechanism capitalism contributes to a better world and succeeds where political regulation is less effective.
The future of ESG is exciting as it continues to grow in size, influence and sophistication. We believe “sophistication” is the most important factor, as it will result in more clearly defined ESG requirements that exclude industries such as those mentioned above.
There is also likely to be more emphasis on companies that offer positive ESG impact, rather than just avoiding companies with a negative impact.
The growth will come from both passive and active funds. Passive ESG funds (such as ETFs) are commonly based on an index created by a third party. These indices focus on being as representative as possible of a theme. This means the index delivers the average result of that theme. Rather than being representative of a theme, active funds attempt to invest in the best combination of stocks within the said theme.
There are two key benefits of active management. Firstly, active funds offer the opportunity to potentially outperform on financial returns and ESG targets. The second advantage of active funds is their accessibility for the investors.
As passive funds are based on a third-party index, it becomes difficult for investors to communicate their views to the ESG decision maker - the index constructors rather than the fund managers. There are fewer degrees of separation with active funds, making it easier for investors to communicate their ESG considerations to the relevant decision makers.
On matters as serious and complicated as ESG issues. this line of communication enhances the audit, compliance and ultimately delivery of ESG goals.
In conclusion, ESG investing has gone mainstream. ESG funds help people to invest according to their ethics, while creating a capitalist platform for a better world. This is not the end of the road and we anticipate continued growth and enhancements in ESG investing with actively managed funds well positioned to lead the way.
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