Harvard Business Review (HBR) wanted to know what institutional investors were doing to address urgent global challenges like climate change and human rights. So, they interviewed the world’s largest asset managers and pension funds including the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS), as well as the pension funds of Japan, Sweden and Netherlands. While in the past, large investment firms mainly paid lip service to sustainability, this survey found that ESG issues are now considered a top priority by executives across the board.
How much of a priority is it? Since the COVID crisis hit, the UN Principles for Responsible Investing has seen a 35% increase in financial institutions agreeing to abide by their six principles.
What’s driving this shift in ESG prioritization? Part of it is due to the how concentrated the asset management industry has become with the top 10 firms holding 34% of all assets. Firms with tens of trillions of dollars under management find it difficult to hedge against potential negative impacts on the global economy from ESG issues. They cannot pass the buck and have come to realize that if the planet fails, so will their investments.
The HBR study also notes that there has been a marked uptick in shareholder resolutions focusing on E&S issues with their share of resolutions up by 45%. This can be attributed to HNW investors directly influencing the investment strategies offered to ensure they align with their values. They’re putting their dollars into investments that focus more into social issues.
And yet, Callan Institute’s 2019 ESG Survey reports that rapid adoption of ESG policies is still fairly fresh, 62% of investors that utilize ESG started doing so in the past five years.
The combination of COVID-19 and recent protests have increased pressure on public companies to demonstrate more social responsibility to attract investors who use ESG metrics in their investment decisions. This has created a new lens in which investors are now looking and considering what companies are valuable.
Firms looking to invest in companies with positive ESG stewardship are in a better position today to find investments that align with their values. There are now effective tools and better data available to make investment decisions. In turn, increased demand has led to more ESG investment options and future generations are more likely to invest in companies catering to ESG issues.
The principles of ESG investing have been approached in several ways since the 1970s. What is markedly different today as compared to the Socially Responsible Investment (SRI) strategies of the 90’s is the presence of “very sophisticated […] and large amounts of ESG data about company performance and the conceptual move towards considering that ESG data and investment analysis based on its materiality.” Says Jon Hale, Morningstar’s Head of Sustainability Research.
What is also different now is that demand for change is coming from consumers, customers, and company employees whereas in the past, it would more likely be the company’s board deciding to throw their weight behind this issue.
Hale explains this new demand for ESG effectively creates an alignment of stakeholders that are saying that they expect companies to address key ESG issues that are affecting them, the company’s own values, and the company’s impact in these areas.
The trend towards greater influence over companies via investing power is expected to increase. Recent surveys have found that up to 95% of Millennials are very interested in ESG and sustainable investing. Fed up with depending on governments to hold companies accountable, Millennials, the fastest growing group of investors, are choosing companies that prioritize ESG considerations.
The tide is shifting as 90% of actively managed firms over $30B AUM have established Responsible Investment Policies, with smaller quickly following. One of the drivers behind this is data showing that Responsible Investment translates into better profits. A study by Harvard Business School 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.”
And these investments are no longer lagging the market. The highest rated ESG companies have outperformed the lowest by upwards of 40%. This is driving more HNW investors to ask their advisors about ESG-themed investments. Even the largest asset managers, like Blackrock, have incorporated ESG criteria into their investment strategies.
But we are now seeing firms paying more attention to the social component of ESG. The urgency that motivated firms to take environmental and sustainable investing seriously has recently expressed itself through the unprecedented COVID-19 and protest events, forcefully refocusing investors’ attention onto social concerns.
In his article in Forbes magazine, George Kell, Chairman of Arabesque, an ESG quant fund, lays out three sustainability movement underpinnings that will emerge from the fallout of pandemic and protest movements.
“First, social issues, such employment conditions, social safety nets and access to health services, will certainly move up on the agenda and reinforce the importance of the ‘S’ in ESG investing. Second, the pandemic has already given a huge push to the digital economy, which will have lasting effects on how we work and consume. Third, the pandemic has heightened awareness of the close relationship between human health and the health of the planet, which may lead to greater respect for and appreciation of natural assets, such as clean air, water and healthy food.”
In addition, racial and gender inequality have finally been thrust into the national spotlight. A vast majority of the public now expects CEOs to affirm that their company hires equitably from a diverse population, and demand they provide specifics. Going even further, a second poll found that 70% will seriously consider how a company’s CEO reacts to social issues in their buying decisions.
One of the top ESG investing trends expected for the coming decade is a greater focus on environmental and social issues. Corporate efforts will not just “move beyond simply ‘giving back to society’” but will also use “sustainability as a tool to systematically manage risk and create long term shareholder value.” Managing the impact that a company has on the environment and society will become an “essential expertise at the board level”, while many boards will begin including sustainability experts.
Also trending in the boardroom, expect a greater focus on diversity and inclusion. Harvard Business Law predicts that by 2030 U.S. boards, especially at large firms, will be closer to gender parity.
Some suggest that we need to take a fresh look at what S means, that it is much more important than previously considered. In a Harvard Law School Forum article, Jonathan Neilanand his team call us to reconsider what S stands for:
“Factors which fall within the ‘S’—frequently customer or product quality issues, data security, industrial relations or supply-chain issues—commonly impact businesses and ‘destroy value’. This prompted us to reconsider if ‘social’ was the correct word for the ‘S’ in ESG and whether ‘Stakeholder’ might be more appropriate. Indeed, the use of the term ‘social’ may have contributed to a failure to conceptualise the ‘S’ in ESG, leading to an absence of focus and measurement from the market.”
This has never been more apparent than now, he continues, when social and health systems are undergoing tremendous strain.
“COVID-19 has reaffirmed that factors relating to ‘S’ are now among the most pressing issues for companies globally. Many employees transitioned ‘overnight’ out of well-performing businesses to effective unemployment. Entire sectors of the economy, and not just the weakest players, are facing a stark and uncertain future. Now, more than ever, a company’s reputation – its ‘licence to operate’ – will be a function of how it engages and manages its stakeholders through this crisis.”
Companies must search out the most relevant ESG factors that impact their business, and take measures to address them because investors are sensitive to how successful their investments perform financially within the context of how they actually achieve that success environmentally, socially, and through good governance.
From 2018 to 2019, funds adding ESG considerations to their investment process exploded from less than 100 funds to over 550, totaling over $933B AUM. ESG tailored products/strategies have become increasingly important for investors, and mutual fund companies are responding to win this business.
The shift towards ESG inclusion is more than just a business consideration. Experts have increasingly emerged encouraging greater consideration of ESG as a parameter for investment. The CFA institute comments that ESG should be factored into the investment process because it’s “consistent with a manager’s fiduciary duty to consider all relevant information and material risks in investment analysis and decision-making.”
Others have taken further calls emphasizing the social purpose of companies. Larry Fink, CEO of BlackRock, the largest US asset manager, writes in his 2018 annual letter, “to prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”
It’s not only the number of ESG mutual funds that have exploded. According to a report by SustainAbility, a sustainable economy think tank, since 2012 the number of ESG ratings agencies has grown five-fold to over 600 agencies. An indicator demonstrating greater reliance by investors and firms on these types of rates for investment decisions.
Nevertheless, it’s important to be diligent when looking for ESG opportunities. For instance, while there are “ESG-based ETFs that focus on promoting racial and ethnic diversity, such as the Impact Shares NAACP Minority Empowerment ETF (NACP), investors shouldn’t assume all ESG funds have the same priorities”, said Dave Nadig, chief investment officer and director of research at ETF Trends. Some funds merely mimic the market and tweak the fund according to performance. Whereas, other funds may exclusively focus on women in governance, or particularly specific environmental causes. The lesson is that ESG concerns and products are quickly growing, but in a field crowded with these types of issues, advisors and investors need to be more diligent with their homework than ever.
It is best to perform appropriate due diligence and to discuss with an advisor before choosing an ESG investment. Given an investor’s ESG goals can potentially span many asset classes, and there are many alternate ESG strategies that can be implemented, the following are a set of high-level best practice approaches for ESG investing.
ESG Integration — Investment decisions should be looked at in a wider context than traditional financial analysis. ESG considerations require a greater analysis of a wide range of risks and opportunities. PRI states, “ESG integration is the analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance (ESG) factors.” Ensure that these risks are explicitly stated.
Active ownership & voting — Do the managers and boards of directors actively engage stakeholders on business strategy and execution? Are they reporting their impact on the specific sustainability issues and policies they promote?
Negative screening — Moral principles are a significant aspect to ESG investing. Exclude those investments and companies that are involved in the industries and activities against your principles (e.g. tobacco, alcohol, gambling, and adult themes).
Thematic — ESG themes can be local, regional, even global and highlight a particular demographic. Understanding what theme complexity best aligns with your ESG goals will help narrow the right choices.
For advisory firms, portfolio rebalancing software can be the most important technology they use. It is software with the potential to provide the greatest ROI by saving countless hours rebalancing portfolios while being applied to every client’s portfolio on a regular basis. As the shifting investment paradigm adopts ESG considerations more prominently, rebalancing software will need to include ESG screens to achieve compliant portfolios.
The developers of the most comprehensive modeling and rebalancing tool on the market, Softpak, have incorporated a tremendous degree of flexibility into its flagship rebalancing software The Universal Rebalancer. Offering attribute level constraints allows advisors the customizability to create attribute-based models and rebalance portfolios at the attribute level to stay aligned with ESG goals and compliance.
The events of 2020 have forced a tide wave of changes in how HNW investors see the market. COVID-19 and the social movement have fired up a new sense of urgency in investing similar to climate and sustainability movements during the early 2000s. Investors want to see their money make a positive impact beyond just investment returns. They are searching for new options and scrutinizing companies to find those with policies that best align with their long-term ESG goals. Advisors should be mindful of the shifting sands and work quickly to accommodate these rising investor sentiments.
One the earliest players in FinTech, SoftPak has developed innovative products at the intersection of business solutions and IT infrastructure since 1994. Our rule-based rebalancing and risk-based optimization software powers some of the largest financial institutions in the world, processing over $500 billion in assets. Headquartered in Massachusetts, SoftPak has offices worldwide.
Click on the link below to have a Softpak representative contact you with more information.