Co-authored by Steve Falci, Chief Investment Officer of Pax World
Until recently, sustainable investing has been regarded, at least in North America, as a niche investment strategy. Mainstream asset managers were often skeptical of it, primarily for perceived performance reasons. Nevertheless a growing body of evidence has shown that taking environmental, social and governance (ESG) factors into account can enhance portfolio management as well as meet the needs of two growing demographics in the market - women and millennials.
Many mainstream asset managers have assumed that ESG factors are detrimental to financial performance, largely due to the conflation of exclusionary practices that may limit an investment opportunity set with ESG integration focused on risks and opportunity. We have been collecting academic and other studies that examine the relationship between various forms of ESG and financial outcomes for years, and have amassed a database of nearly 300 such studies, all of which show that ESG is positively and significantly linked to performance or risk management. Several of these studies are also meta-studies, which statistically evaluate the results of many other studies. One recent example is a paper from the University of Oxford and Arabesque Partners, which found that of the 190 sources analyzed, 88% found that "companies with robust sustainability practices demonstrate better operational performance". Of the studies we have collected, some examine a group of sustainability factors, and some concentrate on just one (e.g., board diversity or environmental compliance). Taken together, this body of literature is a powerful argument for incorporating ESG factors into asset management.
Not every single ESG item is going to matter equally for all companies or at all times as is the case for many intangible assets (brand, patents etc.) considered by traditional analysts. As with all active management, skill and passionate pursuit of unique insights are keys to long-term success. The skilled investor looks for clues in the numbers to find value or risk before the events actually occur; in short, our business is one of skating to where the puck is going to be. Figuring out where that is depends on the totality of corporate performance and impact, not just those that are included in financial reporting. Timing can also be an issue; many investors make the mistake of believing that ESG factors' impact is long-term, and thus less relevant for investment managers who measure the number of years in the investment horizon on the fingers of one hand. In fact, many ESG-related risks are better described as indeterminate-term risks, ones that can occur at any time. A perfect example is that of BP's Deepwater Horizon explosion: the company had an industry-lagging safety record for many years prior to that accident, but the exact timing of the disaster was not predictable. Currently, many investors still see climate change as a long-term risk factor (or set of factors), but the storms, fires, floods, droughts and other incidents that wreak physical as well as financial havoc are already occurring, and will continue to happen at unpredictable intervals.
Integrating ESG also makes good business sense. By 2025, women will manage or control two-thirds of the nation's wealth. And between now and midcentury, approximately $30 trillion in wealth is being transferred to millennials. Women and millennials are, compared with the cohorts who control most wealth now, more interested in making the world better, and that sentiment is expected to carry through to their investment choices. Those facts alone should drive a fairly significant overhaul in how traditional asset managers think. Combine that with the rapidly-increasing evidence showing the financial impact of environmental, social and governance in affecting corporate financial performance, and there are few reasons left not to think about sustainable or impact investing unless, like the fiddler on the roof, you're more interested in tradition than anything else.
1. Note that we use the term "sustainable investing" to cover several other concepts: ESG investing, SRI, and impact investing.
2. Gordon L. Clark, Andreas Feiner and Michael Viehs, "From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance," University of Oxford and Arabesque Partners, September 2014.
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