Why ESG works - and why now

Scott Longley

a group of people sitting at a table in a room with windows

Those of us who can remember life before the internet and mobile phones might be surprised to hear that there is one area of investment where they are clearly lagging that much maligned age group, the Millennials.

Environmental, social and governance investment - ESG for short - is a relatively new focus for the investment world and has a simple premise. It suggests investing in companies according to how they perform against certain key metrics designed to measure the long-term impact of a company's business practices.

The evidence would suggest this investment approach works. "In Europe, academic studies show that companies with strong ESG scores also do well in terms of return on equity," says Andrew Walsh, head of passive specialist sales for the UK and Ireland at UBS.

That is good for the companies that abide by ESG guidelines and it is also great news for those investors who are particularly enamoured with investment that comes with a social edge. Enter the Millennial and, perhaps not surprisingly, more women investors.

A survey conducted among investors in the US in 2014 found that two-thirds of Millennials believed that investments were a way to express social, political and environmental values. This compares with 36% of baby boomers. Meanwhile, a survey conducted by Oppenheimer Funds and Campden Research found that 84% of ultra high-net-worth Millennials expressed an interest in SRI and impact investment while 76% were interested in pursuing ESG-based investment.

The interest in ESG is clearly growing, says Isabelle Bourcier, global head of quantitative and index at BNP Paribas. "They have values and they are looking for ESG to emulate those," she says.

Adam Laird, head of ETF strategy for northern Europe at Lyxor, agrees and adds that consumers are getting increasingly more conscious about their investment choices.

But he adds that they will need to accept the issue of investment bias and what this might mean for returns.

"Through their construction, ESG funds often have a bias towards or against certain sectors," he says.

"This will naturally change their returns. For example, ESG funds avoid oil and gas stocks, so you would expect them to outperform when oil and gas is suffering and vice versa."

Tracking error

Walsh points out that the tracking error of ESG funds versus their benchmarks is not uniform across the globe. He points out that when it comes to the Europe fund, the UBS MSCI EMU (European Monetary Union) Socially Responsible ETF outperformed the benchmark MSCI EMU index in 2017 by nearly 4 basis points (7.25% versus 3.94%).

However, this isn't matched elsewhere. The US SR fund and the EM version both lagged their MSCI benchmarks and, in each instance, Walsh offers up some intriguing explanations.

In the case of the US SRI fund and to an extent the World fund as well), the underperformance is perhaps best explained by the absence in the SRI selection of the FANGS, none of which made the socially responsible grade. Given their outperformance in the recent bull market, it helps explain the lag.

Likewise, for the EM SRI ETF the fact that the fund is underweight China again mitigates against being able to outperform given the Chinese weightings in the main index.

Walsh cautions, though, this picture of "more nuanced that simply a developed world bias" to ESG investing, adding that the underperformance also proves that ESG-led investment fund "have teeth" and that this "gives an honest picture" of the state of ESG developments globally.

Screen time

What is worth looking at is the way that SRI indices are constructed. The MSCI SRI methodology used a three-pronged approach.

First, there is the so-called negative screen of identifying an automatically excluding the sin stocks. That is alcohol, gambling, tobacco, military weapons, civilian firearms, nuclear power, adult entertainment and genetically modified organisms.

The next is where ESG becomes more interesting and involves the assessment of factors that will affect how companies operate. For MSCI there are 37 specific issues that companies are assessed on including carbon emissions, water stress, energy efficiency, renewable energy usage, labour management, health and safety, business ethics, corruption and instability.

The third screen is the ESG controversies score that assesses potential negative ESG impact on businesses. The metrics aim to penalise companies which have specific extreme controversies such as those committed by BP, VW and Exxon to name a few. These are aligned with such norms as laid out by the UN and other organisations.

System addict

Such systems of classification point to why the ETF structure is good for ESG. "Historically SRI was seen as a preserve of active investors," says Laird. All the reports and manager meetings was laborious and time-consuming and would often entail higher fees. But with index providers now doing much of the leg work, it has facilitated the launch of a greater number of ESG-based funds.

"There are a wide range of options for the passive ESG investor, and a lot of them take a very different approach," Laird adds. "Some of the largest, broad ETFs use a scoring system - assessing companies on a range of factors and investing in those which rise above a certain threshold. Others are more focused on a single goal."

What is certainly true is that these funds would appear to be finding a willing audience. Walsh points out that the UBS SRI range now has assets under management of $3.05bn while Bourcier at BNP Paribas says that the ESG funds there have an AUM reaching €4bn.

But the prize could be worth much, much more if those Millennials keep investing the way they do at present. In a note issued at the end of 2016, the equity and quant analyst team at Merrill Lynch Bank of America made the point that ESG funds "were not just for tree-huggers."

"Trends in the US investment landscape suggests that trillions of dollars could be allocated to ESG-oriented equity investments, to stocks that are attractive on these attributes, over the next few decades."

As the Merrill Lynch Bank of America team point out, that is size of the entire S&P 500 at present and represents some target if providers get it right.

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