By focusing on sustainability factors, ESG investing offers the opportunity for investors to make a positive impact.
Environmental, social and governance (ESG) investing has gone from a fringe interest to a dominant market force. In today’s markets, you can hardly escape the subject.
Over just the last few years, there’s been a remarkable surge in the ESG space—the growing subset of responsible investing that incorporates long-term sustainability and ESG considerations into its decision-making criteria. Factors like climate change, for example, are a very real risk—and companies that recognize that risk, and develop a strategy for it, will be better positioned than those that don’t. For example, RBC’s Climate Blueprint is the firm’s enterprise strategy that acts as a guide for how RBC plans to address its own climate-related risks and path to accelerate clean economic growth, and support its clients in a socially inclusive transition to net-zero.
That’s a win-win, producing better outcomes for the planet and society while also generating returns for investors.
“Interest in ESG has only been more pronounced since 2020 due to the pandemic and renewed focus on racial equality,” says Kevin McDevitt, director of global manager research for RBC Wealth Management-U.S.
By focusing on sustainability factors, ESG investing offers the opportunity for investors to make a positive impact. The question, though, is whether they need to sacrifice gains in the process.
According to a growing body of evidence, including research by RBC Capital Markets, ESG principles don’t require investors to give up potential returns, and in fact may add to them. Think of it as a built-in quality screen for equities. If you’re selecting only those companies that have thought seriously about future risks and prepared for them, it would make sense that those companies might outperform in the long term, compared with others that haven’t thought beyond the next quarter.
“That’s one of the main questions we hear: ‘Do I have to give up anything in order to do it?’” says Kent McClanahan, vice president of responsible investing for RBC Wealth Management-U.S. “We’ve found that in normal markets, ESG portfolios do well, and in down markets, you have the added benefit of being invested in companies that have prepared for future risks. Obviously, past performance doesn’t guarantee future results but we feel like clients shouldn’t have to sacrifice to integrate ESG into their portfolios.”
In fact, ESG outperformance has spiked, even as the COVID-19 pandemic hit, he adds, citing the RBC Capital Markets research. That’s because these companies tend to be better run, they use fewer resources and are exposed to less risk.
At the height of the pandemic, Chicago-based fund research firm Morningstar looked at first-quarter 2020 performance—a rocky period for equities—and found seven out of 10 sustainable funds finished in the top half of their categories. And 24 out of 26 ESG index funds bested their conventional counterparts.
Once investors are interested in an ESG approach, they should start thinking about how to construct a portfolio. And that’s no easy task, given the different niches and terminology related to responsible investing.
Responsible investing is an umbrella term encompassing the approaches used to deliberately incorporate ESG considerations into an investment portfolio. There are four main approaches to this data: ESG integration, ESG screening and exclusion, thematic ESG investing, and impact investing.
ESG integration involves systematically incorporating material ESG factors into investment decision-making to identify potential risks and opportunities and improve long-term, risk-adjusted returns. “You might look at a company’s greenhouse gas emissions, or water usage, or labor relations, or workforce diversity,” says McClanahan.
With ESG screening and exclusion, meanwhile, investors apply positive and negative screens to include or exclude assets—screening those companies you do or don’t want to be a part of. For example, perhaps you’re morally opposed to investing in tobacco companies.
Next, with thematic ESG investing, investors seek out a particular ESG-related theme (i.e., clean energy, climate, water, or gender equity) or seek to address a specific social or environmental issue.
Finally, there’s impact investing, where you can draw a direct line to the positive changes your money has brought about. Impact investors hope first and foremost to generate social or environmental impact, but also want to earn a return on their investment. However, they may be willing to take a loss as long as some tangible result for the investment can be seen. For example, in the fixed-income arena, you could buy bonds that would be used to fund water projects in Africa.
These four approaches help solve a major problem for investors: if almost every company is now saying it’s ESG compliant because it’s the trendy thing to do, how can you really tell who is operating by those principles, and who isn’t?
“It’s hard not to be skeptical of the ESG explosion because everybody’s now saying they’re doing it,” says McClanahan. “It’s a lot harder for investors to understand what companies are actually doing.”
Beyond the fact that corporations are all claiming to be doing well, asset managers are similarly claiming that they consider ESG factors when creating their portfolios. Because of this explosion of interest, RBC Wealth Management’s global manager research (GMR) team has enhanced their responsible investing and ESG due diligence process for assessing and categorizing a manager’s incorporation of responsible investing and ESG data into their investment process. GMR evaluates investment managers on their firm commitment, investment professionals, and investment process.
While ESG momentum has been unstoppable in recent years, the COVID-19 crisis ground economies to a halt and turned the investing world on its head, forcing some to ask whether this interest in ESG would continue.
Indications are that it has. For the sixth consecutive year, sustainable funds set an annual record for net flows in 2021, nearly reaching $70 billion, according to Morningstar.
A critical factor for an enduring ESG approach is that, in recent years, investing decisions have been tilting more toward women and younger investors, both of whom have demonstrated a laser focus on sustainability issues. According to a recent survey of high-earning and high-net-worth millennials conducted by RBC Wealth Management–U.S., nearly 85 percent of respondents said it’s important to align their investments with their values, such as ESG principles.
“Both those sets of investors really care about where their investments go,” McDevitt says. ”They want to direct their money to companies that are doing right.”
Due diligence processes do not assure a profit or protect against loss. Like any type of investing, ESG investing involves risks, including possible loss of principal.
Past performance does not guarantee future results.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.
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