Commentaries

PMC Weekly Review - October 21, 2019

A Macro View: ESG Entering the Mainstream

Funds that focus on environmental, social, and governance (ESG) advancement attracted about $8.9 billion worth of net inflows during the first six months of the year, according to data from Morningstar. That is more than a 60% jump from the $5.5 billion in inflows for all of 2018. According to a report from US SIF, ESG investing now represents $12 trillion in assets under management and is growing by more than 13% CAGR in the US.1 Trends like these show that the inflows into ESG products are unlikely to slow anytime soon.

This growth in ESG investments can be attributed to a number of reasons. A Bank of America study showed that millennials are the demographic group most eager to invest using ESG and impact criteria, and more than half the US workforce will be millennials in the next six years, according to another forecast by Inc. magazine. This demographic change is expected to drive the growth in ESG investments. Regulatory pressures have required companies to provide more transparent ESG and social impact data, making it easier for advisors to evaluate a fund’s underlying investments. Additionally, the increasing supply of ESG investment products has reduced the cost of investing in ESG funds.

In the past, ESG investing was seen as a niche sector that restricted the fund manager’s investment universe, because such funds often excluded companies seen as harmful to the environment or society, such as oil companies or arms manufacturers. Therefore, investors were often made to believe that they had to accept lower returns because of their convictions. This is changing too. Data from a recent study by MSCI showed that ESG-rated companies were more profitable, paid higher dividends, and had better risk-management practices.2 The study also stated that “ESG has affected the valuation and performance of companies, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk).” In response to this wider demand, the financial services industry is launching a slew of new exchange-traded funds (ETFs) and mutual funds aimed at this socially conscious universe of investors.

The growth in ESG integration can be seen across industries. Even the US 401(k) industry, which is usually slow to adapt to new trends, has started to integrate ESG investments. Of 401(K) advisors surveyed, 52% use ESG criteria for retirement portfolios, according to a survey by Ignites. However, pension funds in Europe may be leading the ESG investment movement. Finland's largest pension fund invested more than $800 million in iShares ESG MSCI USA Leaders ETF (SUSL) in the second quarter launch and invested a similar amount in Xtrackers MSCI USA ESG Leaders Equity ETF (USSG) in the first quarter.

Data is another key lubricant in the rise in ESG investing. Advancement in machine learning and data analytics offers a great potential to gain competitive advantage in ESG investing. Therefore, algorithms can be designed to select ESG stocks with the highest growth potential, with minimal human intervention. This has enabled quant managers who traditionally use factors such as value, size, momentum, growth, and volatility to integrate them into their ESG investment process. According to Preqin research, nearly 30% of hedge funds say they are using ESG considerations to form investment decisions.

However, the future is not without challenges. ESG integration is gaining acceptance, but from a low base. Close to 90 ESG ETFs track roughly $16 billion in assets in the US, a mere fraction of the more than $4 trillion of total ETF assets. ESG integration in fixed income investments is well below that of equities. A concern to investors is that ESG mutual funds and ETFs offered to investors may be driven by marketing decisions and may not be true ESG investment products. In addition, ESG data has improved in recent times, but advances in quality and comparability of data still have a long way to go. Clearly, the industry could identify a single ESG-reporting standard to streamline the data-collection process and produce higher-quality, comparable data. The Sustainability Accounting Standards Board (SASB) is working on providing globally applicable industry-specific standards and sustainability metrics for the typical company in an industry.

Worldwide investor demand for ESG investing is certainly strong: 76% of individual global investors and 71% of US investors believe it is important to have the ability to invest according to personal values and ethical requirements, according to a survey conducted by Natixis Investment Management. However, to realize this potential and to ensure the ESG theme is not another investing fad, policy makers, corporations, and investors must find a way to address the unique challenges the industry is facing.

 

Ramasubramaniam, CFA

Investment Analyst

 

References

1 2018 Report on US Sustainable, Responsible and Impact Investing Trends; US SIF; 2019

2 Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance; Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy, and Laura Nishikawa; 2019

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