ESG Investing Overview: What You Need to Know About ESG

Three little letters have come to mean a lot in the investment world: ESG.

The acronym signifies investing based on environmental, social, and governance benefits, or firms’ efforts to do good in the world on one or more of those dimensions: reducing waste/pollution, improving working conditions, enhancing boardroom diversity, and many others. Companies invest in ESG efforts, and funds invest in companies pursuing ESG.

But do ESG investments live up to the hype? Do they actually deliver better or comparable returns as part of the much-touted double or triple bottom lines many companies and investors seek today?

Let’s take a quick tour through the broad landscape of ESG investing, including what ESG is, different ESG investment strategies, drivers of these investments, associated returns, and the ESG-investment labor pool.

What is ESG?
We defined ESG briefly above, but bear in mind that such investments and funds are associated with multiple labels including:

• Sustainable investing
• Impact investing
• Socially responsible investing
• Corporate social responsibility (CSR)
• Corporate citizenship

It’s all part of the growing notion that traditional shareholder value isn’t the only kind of value that companies and investors should pursue: returns can and should go beyond financial, the reasoning goes, to include broad positive impacts on society.

That might mean doing something positive for society, such as investing in businesses that promote employment of underserved community-members, environmental benefits, or other positive externalities. But it can also mean not doing something considered negative for the public, such as avoiding investments in businesses that sell cigarettes or cause pollution.

ESG Investment Strategies
There are multiple ESG investment strategies to pursue separately or in combination.

These include:

• Exclusion: As noted above, specific funds might just exclude “sin” stocks such as those of corporations with offerings or practices such as tobacco, firearms, gambling, fossil fuels, or strip-mining. ESG funds have evolved more toward the categories below over recent years.
• Positive/best-in-class screening: Here, funds focus on investing in firms that are actively pursuing ESG along multiple dimensions. The TPG Rise Fund is an example.
• ESG integration: Investment managers include ESG factors in their analyses, but have a broader approach than funds associated with positive/best-in-class screening.
• Activist: Using sizable stakes in companies as motivation to drive ESG. Hedge funds such as Blue Harbour and Jana Group are some examples.

Drivers of ESG Investment
The trend toward ESG investment has grown across dimensions including geography, type of investor, and type of investment.

A 2018 survey, for example, found that 74% of employees of Fortune 1000 companies want their 401K plans to include socially responsible investments, a large rise from previous figures.

Global ESG investment figures have followed that trend: total ESG investments worldwide now total about $23 billion with about 275 mutual funds and ETFs contributing to that figure. Well-established ESG-dedicated funds at the time of this writing include Nuveen’s NuShares ESG International Developed Markets Equity ETF and the Pax Ellevate Global Women’s Leadership Fund.

So it’s not surprising that a recent survey of financial planners showed that they expected to increase their use of ESG funds with clients about 20% in 2018.

The push for ESG investment can be tied largely to groups pushing for more ethical investment. These include women and Millennials. For example, a Morgan Stanley survey showed that 86% of Millennials—compared to 75% of the general population—were interested in socially responsible investing, a figure expected to grow even further. Moreover, Millennials exert influence not only with their voices but their wallets: one study showed that Millennials accounted for 23% of all US millionaires.

Investment Performance
One of the largest questions surrounding ESG investment funds is whether they are effective: beyond serving a social purpose, do they generate competitive risk-adjusted returns?

Many within and outside the investment world remain skeptical and prefer to keep the focus where it has traditionally been: on companies that maximize shareholder value. There is evidence that ESG funds may fail to achieve the returns of their more traditional counterparts.

One financial advisor group, for example, surveyed available ESG-fund-return research to conclude: “The bottom line is that, while ESG investors seem likely to be sacrificing some returns to express their social preferences through their investments, it also seems likely there may be some offsetting benefit, though it may be marginal, in the form of reduced portfolio risk.” The reduced return referenced then is due to the focus on multiple types of value when deploying capital.

On the other hand, there is evidence for the strong performance of ESG funds. If nothing else, the extra level of due diligence around ESG ensures investment managers get to know the companies they invest in even more intimately, which should correlate to better long-term returns.

The data is limited and it is not black-or-white: much depends on how a given ESG fund makes investment decisions. For example, recent research shows that more “material” ESG investments by businesses, or those associated more closely with the firm’s core competence or product—are more likely to lead to better financial performance, and thus to better returns for ESG investors.

Small, Growing Labor Pool
The contours of hiring patterns related to ESG investment are still forming.

On one hand, many recent MBAs have an interest specifically in ESG investment—so the talent pool in this area is available. On the other hand, the number of ESG-focused funds remains a small percentage of the total number of funds, so there an oversupply relative to the number of open positions, and lower relative compensation as a result of the supply-demand imbalance.

The good news is that more funds are focusing on ESG investments—and devoting more capital to the endeavor—so there will be rising demand for ESG expertise and specialization (such as focusing on Food, Energy, Education, or other industries for example) will have increased value as the space matures. Naturally, the ability to execute higher-return ESG strategies will also be valuable over time as investors start to learn more about the potential costs of expressing their values through capital deployment.

Entry-level ESG investment professionals today are making a calculated bet—they are making less in compensation than their traditional counterparts—but they will be well-positioned from a career perspective and should see their economic rents rise rapidly if capital allocation to ESG continues to grow as their will be a limited supply of professionals with their skillset.

The Bottom Line
So what’s the bottom line about ESG investments?

For one, they don’t seem to be going anywhere. The focus on more transparent, values-based, ethical investing appears to be much more than a passing fad; as Millennials invest more of their wealth, the call for ESG-focused funds will likely only grow louder. Returns are no longer the only thing that matters in investment. Period.

At the same time, ESG investing remains at least as much art as science. While investment managers and researchers are making headway on what types of ESG investments are more likely to drive strong returns, the issue remains largely a black box.

Those interested in a career in ESG investing should explore this promising area fully. But they should do so with their eyes wide open and the recognition that the ESG story will continue to evolve.