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 issues 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 recently published its Climate Blueprint, which acts as a guide for how the firm will address its own climate-related risks.
That's a win-win, producing better outcomes for the planet and society while also generating returns for investors.
“Interest in ESG has only gotten more pronounced in 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.
And you can't dispute the numbers. ESG investing now totals US$17 trillion, according to a 2020 biennial report from the Forum for Sustainable and Responsible Investment (US SIF). That's up from $12 trillion in 2018.
Gains for the planet and portfolios
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.
How to construct an ESG portfolio
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.
There's socially responsible investing (SRI), which typically means negative screens, explains McClanahan—eliminating those companies you don't want to be a part of. For example, perhaps you're morally opposed to investing in tobacco companies.
Then there's impact investing, where you can draw a direct line to the positive changes your money has brought about. That's easier to do in the fixed-income arena, where you could buy bonds, for example, that would be used to fund water projects in Africa.
Then there's ESG, which usually refers to a positive focus on best-in-class performers. Instead of eliminating whole sectors, you're looking for “companies that are doing better than their peers on environmental, social and governance issues,” says McClanahan. “You might look at their greenhouse gas emissions, or water usage, or labor relations, or workforce diversity.”
And investors can drill deeper into these guideposts and ask questions like: does a company take environmental issues seriously, with a thoughtful approach to water usage, greenhouse gas emissions and waste management? What about social issues like workplace health and safety, community and government relations, corporate philanthropy and workforce diversity? Is it transparent in its governance structure, with best accounting practices, reasonable executive pay, an accountable board of directors and regulatory compliance?
This screening helps 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 created a framework for segmenting managers who are authentic in their ESG integration vs. those who are not. GMR evaluates investment managers on their firm commitment, investment professionals, and investment process. Using this criteria, they have created a system to help segment authentic ESG managers.
ESG investing in the new normal
While ESG momentum has been unstoppable in recent years, the planet has now been hit with the COVID-19 crisis, grinding economies to a halt and turning the investing world on its head. In the face of such challenges, it may be fair to wonder whether this interest in ESG will continue.
Indications are that it will. Throughout 2020, responsible investing products have seen extremely strong flows. Morningstar reported that through the third quarter of 2020, sustainable funds have seen $30.7 billion in flows, up from $21.4 billion in all of 2019.
Even in March, when equity investors everywhere started fleeing for the exits, ESG fund flows were still positive. Morningstar's head of sustainable research, Jon Hale, quipped in a research note: “Yes, you read that right.”
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.
“Female clients and advisors are a much bigger force in the investing world now, and ESG issues resonate with them more than men,” says McDevitt. “Also, Millennials are now growing up and gathering assets, and are on the receiving end of one of the biggest generational wealth transfers in history.”
“Both those sets of investors really care about where their investments go,” he adds. ”They want to direct their money to companies that are doing right.”