Investing for Returns or Investing in ESG Strategies: A False Dichotomy
Clients are asking more than ever of their advisors. Routine conversations around having enough to retire, saving for college, or leaving a financial legacy have become more robust as individuals have come to recognize that these matters have both financial and non-financial impacts on their lives. The emergence of “responsible investment” solutions has created an opportunity for clients to approach their portfolios more holistically and in line with their beliefs and values. The historical perception of a trade-off between optimizing returns and reflecting values is a false dichotomy.
Over the past decade, investors have become increasingly accepting and proactive about incorporating socially conscious considerations into their investment processes. Recognizing the importance of this development, the United Nations established the Principles of Responsible Investment (PRI), which assists investment managers, service providers and asset owners in their efforts to incorporate environmental, social and governance factors into their decision-making. Today, the PRI boasts more than 1,700 signatories, with assets in excess of $68 trillion globally.1 According to the Forum for Sustainable and Responsible Investment, more than one out of every five dollars invested by professionals in the United States considers sustainable, responsible, or impact investment factors.2
Responsible investing generally involves the consideration of environmental, social and corporate governance (ESG) factors in investment decisions alongside financial information. Most current approaches fall into one of three broad categories: ethical investing, ESG investing, and impact investing. The differences among these strategies, while subtle, are important.
Ethical investing, sometimes referred to as socially responsible investing (SRI), uses negative screening to exclude companies deemed to be morally or ethically undesirable, such as alcohol, tobacco, gambling and firearms. Critics have argued that this exclusionary screening process can hurt returns by restricting the universe of investable companies. ESG strategies seek to solve this problem by taking an integrated approach that considers a broader range of factors alongside financial factors. Lastly, impact investing endeavors to invest in companies that will generate a measurable social or environmental benefit alongside an acceptable investment return. This latter approach currently is found mostly among private strategies.
The ESG investing approach is the most easily accessible to investors and well positioned to blend social and financial considerations appropriately for investors.
Examples of ESG factors include:3
The perception that ESG investing must come at the cost of lower investment returns is subsiding. The incorporation of ESG in the investment process can enhance long-term performance:
- First, a well-run ESG strategy is future-focused and therefore well positioned to capitalize on future trends such as environmental change, increased oversight, and consumer demand for brands perceived as sustainable and socially responsible – especially among millennial investors. In this sense, the integration of ESG factors may, in fact, help a manager identify industries, companies, and management teams that are positioned to excel over the longer-term horizon.
- On a related note, there are reduced risks associated with companies that exhibit strong ESG credentials. Indeed, these companies are less likely to be fined for environmental negligence, sued by shareholders for poor governance, or face reputational backlash for poor labor conditions and should be ahead of their peers in more stringent regulatory environments.
- Another reason why higher-rated companies in an ESG framework can generate better returns involves employee engagement and workforce diversity. Studies show that employees that find meaning in their work are more productive and are less likely to leave their employer, which translates to better financial performance. In addition, research shows that companies with more diverse workforces outperform their peers.
- Next, a recent study concluded that companies with higher ESG ratings are more heavily owned by long-term investors. Long-term investors typically tend to be patient and less focused on short-term measures such as quarterly earnings reports.4 Evidence suggests that this type of shareholder base can lead to relatively lower levels of volatility.
- Finally, shareholder value is increasingly being sourced from non-financial factors such as brand, corporate culture, human capital development, and reputation. All of these traits can be enhanced, in part, by a company’s ESG practices.5
In light of the above, a growing number of academic studies have come out in support of incorporating ESG factors into investment processes. Many of these studies have concluded that integrating ESG factors at worst has no financial impact and at best can improve long-term risk-adjusted returns.
In turn, investing in ESG strategies increasingly is being adopted by investors even in the face of an ever-expanding universe of available investing styles and themes. One must always be vigilant about identifying and resisting phenomena that are just short-term hype, but ESG investing is more than that. It presents an important opportunity for those clients who wish to incorporate it into their portfolios. These investors have rationally come to appreciate the expected benefits of proactively identifying companies and management teams that are forward-thinking, focused on long-term trends, better at identifying and mitigating a broad spectrum of risks, and committed to best practices in governance and corporate culture.
Anecdotally, our own personal experience has been that by addressing these factors, we, too, have experienced significant business growth and employee engagement. Some of the key factors we have incorporated into our business, and on which we believe we are seeing returns, include:
- Environmental Factors: designing our physical offices to be compliant with sustainable business practices; and supporting environmental clean-up efforts
- Social Factors: contributing to community organizations; supporting the health and welfare of our employees with holistic benefits and wellness programs; ensuring a higher percentage of women in the highest leadership positions; and supporting diversity efforts with representation in key industry organizations
- Governance Factors: creating an inclusive governance structure; and utilizing third-party auditors and consultants
This experience only bolsters our overall thesis that investing for returns and investing in ESG strategies are not mutually exclusive and actually represent a false dichotomy.