What is ESG investing?
ESG stands for Environmental, Social and Governance and ESG investment strategy considers these practices when picking companies or funds to invest in. This approach to investing formed as a natural offshoot of the early social engagement model of Corporate Social Responsibility (CSR) and has since gained momentum in line with growing regulatory pressure, especially around environmental policies.
ESG investing is different from socially responsible investing, which is more heavily skewed towards ethical considerations, and sustainable impact investing, which gears investments towards “positive impacts” separated from financial goals.
According to research by Morningstar, global sustainable fund assets reached $2.2tn (£1.62tn) in Q2 2021, with 4,929 funds focusing on a sustainable approach to investing. Major trading platforms have accordingly begun offering their own funds: FTSE’s 4Good UK Index and Dow Jones’ Sustainability Indices are just two examples of a growing number of funds capitalising on growth in the economy of tomorrow.
And ESG funds are heavily invested in that future. In April 2021, MSCI took a stock check of the top 20 ESG funds, which comprise a mix of exchange-traded funds (ETF), active funds and index funds. Emerging themes in top funds include a heavy exposure to information technology, communications, consumer discretionary and healthcare.
Energy companies, on the other hand, are purged from ESG inclusion for their negative effect on the environment and contribution to global warming. Only one of the top 20 companies surveyed held more than a 5% stake. This, MSCI says, was a big contributor to ESG funds having generally outperformed traditional funds since the onset of Covid-19.
How are ESG funds rated?
ESG ratings operate much in a similar way to company debt ratings, most prominently carried out by Fitch. MSCI is one of a handful of regulators who publish ratings ranging from CCC to AAA, encapsulating ‘laggard’, ‘average’ and ‘leader’.
Its methodology identifies material risks to – and opportunities for growth for – companies in different industries, based largely on their exposure to potential regulatory changes or the gradual reduction of natural resources.
Pros of ESG Investing
Data released in February by Morningstar showed net inflows for sustainable open-end and ETFs available to European investors of €233bn ($280bn), almost double that of 2019. Inflows for Q1 2021 alone reached a record $184bn, and while Q2 2021 data shows a slowing in investment, overall 2021 figures remain above 2020.
Multiple indicators released by Hargreaves Lansdown suggest surging demand as part of more sustained long-term success. Flows have increased by nearly 6,000% over the past five years as they shed their reputation as a millennial fad, with popularity now highest among 30-54 year olds and those approaching retirement.
In a note, Emma Wall, head of investment analysis at Hargreaves Lansdown (“HL”), said: “Strong relative and absolute performance helped push funds in front of previously sceptical investors’ eyes, while both the pandemic and associated lockdown brought environmental and social issues to the top of the news agenda. Expectations for 2021 flows were therefore muted after such a strong preceding year, but once again HL clients have put their money where their morals are and in-flows to responsible investment funds have hit yet another record high.”
A big reason for its success, proponents argue, is reduced volatility thanks to lowered dependence on unstable regulatory frameworks. According to McKinsey & Co., typically one-third of corporate profits are at risk from state intervention, rising to 50-60% for banks and 60% for sectors reliant on government subsidies, such as automotive, aerospace and tech.
Russ Mould, investment director at AJ Bell, echoed this sentiment. He said: “From the narrow perspective of financial investment, the theory is that firms which pass rigorous ESG screens and filters will be seen as less risky, as there is less chance of them facing regulatory pressure or public opprobrium owing to their business model or any damage they do or mistakes they make.
“Firms that are seen to be less risky could well enjoy a lower cost of capital, making it easier for them to generate a return on capital employed that exceeds that cost of capital and thus create shareholder value. In theory those stocks may also enjoy premium valuations as a result.
“Those that fail the tests may languish and suffer discount valuations, relative to the wider market because of the perceived danger of clean-up costs, regulatory fines or even, in extreme cases, loss of license to operate, should their business model prove obsolete.”
Built for the future
While surges in 2020 likely represented a premature spike in performance, it points to an encouraging trend. A survey by Blackrock shows investors intend to increase their 18% share of investments that are sustainable to 37% across the globe by 2025. Brown Brothers Harriman carried out a survey that implies a growing market for ESG ETFs in Greater China. The survey suggests that in five years, 53% of investors expect to have at least 11% of their portfolio in ESG ETFs.
Outlooks for ESGs accordingly remain optimistic. Research by pwc last year forecast European ESG assets to increase to between €5.5tn and €7.6tn by 2025, which would represent up to 57% of total mutual fund assets in Europe, up from 15.1% at the end of 2019.
- Pitfalls of ESG investing
ESGs remain in their ascendancy, and as a result remain susceptible to compromise from a number of angles, including transparency and a lack of long-run evidence of their link to profitability.
Lack of transparency
Chinese markets, where growth is expected in swathes, is a primary culprit when it comes to poor adoption of best practice in ESG frameworks. A report by JP Morgan highlights the myriad of barriers to consistent good practice in China, which inhibits international investment.
The report says: “The content of ESG reports in China is highly qualitative. Quantifiable metrics, which are vital for investment analysis, are limited. The transparency of the methodology and the consistency of disclosure are additional concerns for investors.”
It’s a problem that seeps into the decisions of investors in developed economies. According to a July Index Industry Association (IIA) survey, which took the opinions of 300 US and UK asset managers, 63% highlighted a lack of data as a major barrier to ESG implementation.
What about growth?
With the 2020/21 success of the ESG market, questions have inevitably risen over a different kind of ESG sustainability: that of its own growth rate.
The first obstacle is proving its link with profitability. In a blog post, Aswath Damordan, professor at the NYU Stern School of Business, called into question the validity of this correlation, highlighting that companies who perform better find it easier to comply with ESG standards.
If that is the case, it would spell trouble for both companies hoping to grow while keeping social conscience at the forefront, and for investors looking to build with this in mind.
Russ Mould sounded a similar warning: “Valuation is the ultimate arbiter of investment return and paying any price to access a hot, or appealing, narrative is not necessarily a good investment strategy.
“More hard-nosed investors will point out that coal and oil and gas and uranium prices have all surged in the past 12 months and anyone who spurned those sectors on ideological, rather than financial, grounds, will have missed some potentially rich-pickings.”
“A wider market accident – caused by inflation, a tightening of monetary policy that is faster than expected or an exogenous shock (such as 2020’s pandemic) – could knock confidence, lead to losses elsewhere and oblige investors to sell holdings where they have profits to cover those losses, or at least tempt them to lock in gains where they have them.”
Ethical investing funds: Largest US-traded ESG ETFs
Exchange-traded funds offer a more stable entry into ESGs for tentative investors yet to find their feet in the ESG sphere. The following are among the largest ETFs with AAA ESG rating that are traded on the US market by Asset Under Management (AUM) value.
iShares Semiconductor ETF (SOXX)
iShare’s largest ESG ETF by AUM is its Semiconductor ETF, with a AUM value of $7.08bn, and a lower expense ratio of 0.43%, which reflects its deepened concentration in fewer holdings.
The fund has a near 100% exposure to the semiconductor market, under the broader sector of information technology, with a total of just 30 holdings in the ETF. Intel Corporation makes up 8.43% of the fund, with Broadcom Inc. making up 8.24%.
iShares ESG Aware MSCI USA EAFE ETF (ESGD)
Blackrock’s iShares have made strong inroads into the sustainable funds race. The group uses ‘sustainability screens’ to determine investment behaviour, based on percentage of revenue earned from disqualifying activities, like civilian firearms or tobacco.
Its iShares ESG Aware MSCI ESGU ETF is the second largest US-traded ESG ETF by AUM, which stands at $6.77bn, with an expense ratio of 0.20%.
VanEck Semiconductor ETF (SMH)
This ETF invests in stocks of US-listed semiconductor companies including midcap and foreign stocks. The requirement for inclusion is for at least half of the revenue to come from production of semiconductors or semiconductor equipment.
The fund holds $5.93bn in AUM, with the expense ratio of 0.35%. Its top holdings include Taiwan Semiconductor Manufacturing, NVIDIA, ASML Holding and more.