As we continue to move out of the pandemic and closer to our new sense of normal life there is growing concern about the condition of the environment and an increased interest in taking purposeful action to reverse man-made climate change. All generations of consumers are gravitating toward businesses that make environmentally conscious choices, and this trend is exaggerated in younger folks. This behavior is not just found in consumers; investors are increasingly demanding that their money be allocated to companies that consider the health of the natural environment in their business decisions.
ESG stands for Environmental, Social, and Governance.
Public companies are rated based on their adherence to the principals of ESG investing. First, the subject company must measure and attempt to reduce its negative impacts on the natural environment. Second, the company must work towards the equitable treatment of stakeholders both within and outside the company. Lastly, the company must have quality leadership, must treat its employees and shareholders well, and it must conduct business in an honest manner (Investopedia). Some companies do well in all three areas, others shine in one or two. Some companies receive low marks across the board, earning a low ESG rating.
Socially responsible investing (SRI) refers to owning shares in companies that have good ESG ratings compared to other companies in the same industry. These are companies that pay more attention to the impacts their business operations have on the world around them, and they consistently innovate to become more sustainable. SRI is becoming more of a focal point for institutional investors. According to Nasdaq.com, "...75% of them considered ESG factors an integral part of sound investing."
The images below are taken from the MSCI’s ESG rating research tool:
In recent years, Socially Responsible Investing has experienced unprecedented growth. In the 1st quarter of 2021, U.S. sustainable funds saw $21.5 billion in net inflows, which tops the $20.5 billion in the 4th quarter of2020, more than doubles the $10.4 billion experienced in the 1st quarter of 2020, and is also about 5x larger than the inflows during the 1st quarter of 2019 (Morningstar.com). Investors have taken notice of these upward trends because “Around 51% more institutional investors and 45% more fund selectors engaged in active ownership of ESG investments in 2020, compared to 2019…” (Nasdaq.com).
One of the main catalysts for SRI growth has been the COVID-19 Pandemic. This historical period, stretching well into its second year now, appears to have changed the perspectives of a lot of people and has accelerated the SRI trend.
The concept that all human activity is interconnected is more accepted because of the pandemic. Neither a virus nor climate change cares about man-made political borders. Supporting businesses that understand this and work to fight back against climate change is becoming more of a “must have” for consumers when people realize that the world economy is impacted by social and environmental change (EY.com). Companies that are aware of this trend and act on it will have a competitive advantage.
Consumers are not the only ones noticing the initiatives that certain businesses take; investors notice as well: “…35% of institutional investors pointed to the influence on corporate behavior as a major reason why they have adopted these [sustainable] investments” (Nasdaq.com).
And not only do investors believe that working towards sustainability is the right thing to do, they also believe they can profit from it because “About 53% [of] institutional investors agreed that companies with better ESG track records generate better investment returns” (Nasdaq.com). The combination of social, environmental, and financial benefits makes for an attractive investment.
During the COVID-19 pandemic, ESG fund performance, however, did not significantly outperform the market:
This chart compares the SPDR® S&P 500 ETF Trust (SPY) and the iShares MSCI KLD 400 Social ETF (DSI). DSI tracks the MSCI KLD 400 Social Index, which measures the performance of U.S. equities with good ESG ratings. Since it is one of the first SRI indexes, it is a common reference point in the ESG investing space. The chart captures the period between March 5th, 2020 and March 5th, 2021, which shows a minor outperformance for the ESG sector. Looking at a longer timeframe, historical performance of 5 or 10 years shows that ESG funds generally tracked the market aside from an occasional 2-3% disparity that did not persist. This can give investors confidence that an SRI portfolio will track the performance of a standard portfolio fairly closely.
There is strong evidence supporting a continued increase in popularity around Socially Responsible Investing. As time goes on, the financial sector will move more toward sustainable investing for several reasons: First, consumers are rapidly shifting toward environmentally friendly companies, and as they migrate, so will investors. Second, as younger generations come to power, efforts to create a more sustainable future will become commonplace in both industry and politics. Finally, the corporations that fail to adopt environmentally and socially responsible policies will hold less appeal to a large group of investors, creating a competitive advantage for sustainable companies.
Given the past year’s volatility, we thought it might be helpful to post some insights on what happened over the course of 2022 and a look ahead at what to pay attention to in 2023.
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