403(b) Curriculum Library

Making Sense of ESG Investing

Environmental, Social and Governance (ESG) investing, often referred to as sustainable investing, has been around for decades but has gained significant prominence in recent years, with record-setting inflows into ESG funds for the fifth consecutive year. This momentum has accelerated since the beginning of 2020. According to Morningstar, sustainable funds in the United States gathered an estimated $10.4 billion in the second quarter of 2020 alone (1). In addition, ESG funds performed well relative to conventional funds during the volatile first quarter and continued to perform well in the second quarter, contributing to their outperformance year-to-date. The recent outperformance of ESG strategies and current social and economic concerns have emphasized the need for investors to consider ESG-related risks in their portfolios and affirmed ESG as a mainstream investment strategy.

Sustainable Funds Estimated Annual Flows

Source: Morningstar

The Basics of ESG Investing

The term ESG investing was officially adopted by the United Nations in the early 2000s. In 2015, the UN introduced 17 Sustainable Development Goals, or SDGs, providing a useful framework to guide impact investing in public equities and fixed income. Investors are increasingly applying the non-financial factors of environmental, social and governance as part of their analysis process to identify material risks and growth opportunities. While ESG investing grew out of investment philosophies such as socially responsible investing (SRI), there are key differences. Earlier models typically used value judgments and negative screening to decide in which companies to invest, avoiding disagreeable businesses or “sin stocks” like alcohol, weapons, tobacco, gambling, nuclear power, fossil fuel, and adult entertainment. ESG investing and analysis, on the other hand, looks at finding value in companies, not simply at supporting a set of principles. While SRI uses exclusionary filters to keep companies out of portfolios that do not meet certain criteria, ESG opts-in companies that are making a positive impact in the three factor areas (2).

ESG Factors

Source: DWS Investment Management

While trends have been more focused on the environmental aspect of the analysis, particularly when it comes to climate change, recent developments for social justice and a push for greater diversity have resulted in a broader emphasis on racial issues, particularly from institutional investors. Since ESG portfolios incorporate all of these issues and look to find companies that score well with each criteria, this sparked greater interest in ESG portfolios.

Managers use various approaches to build socially responsible/ESG portfolios, including exclusionary screening, best-in-class selection, active ownership, thematic investing, impact investing, and ESG integration (which is the most common approach). ESG issues, such as a company’s environmental damage, abuse of human rights, or labor relations, often draw the attention of headlines and may cause a sharp drop in stock prices. Longer-term megatrends, such as the scarcity of a natural resource or changing demographics (e.g., the economic rise of pro-sustainability millennials), are also relevant to the investment risk and return across asset classes. Thus, ESG integration strategies look at ESG factors in the investment process to identify potential risks for investments that could materially affect financial performance. The number of conventional funds that now say they consider ESG factors has grown enormously, to 564 funds from 81 in 2018(3). This explosive growth of funds considering ESG factors reflects the growing recognition among asset managers of the relevance and materiality of ESG factors in evaluating investments.

ESG Investing Approaches

ESG Performance

ESG funds outranked their conventional peers in the second quarter of 2020. After outperforming their peers on a relative basis in the first-quarter downturn, the opposite might have been expected in the second quarter, as stocks posted their best quarter since 1998. On a year-to-date basis, 47% of U.S. large blend funds with an ESG mandate scored in the top quartile of Morningstar’s large blend category.

U.S. Large Blend Sustainable Equity Funds: Year-to-Date Rank by Category Quartile

Source: Morningstar

Looking at average sector exposures, ESG managers do tend to overweight the technology sector, which has been one of the best-performing sectors, while being underweight in the underperforming energy sector. Impact from the sector weights attributes close to an estimated 1.2% performance difference between non-ESG managers and ESG managers on a year-to-date basis. However, ESG fund managers’ outperformance, relative to conventional managers, cannot only be attributable to having less weight in the energy sector. With the energy sector being the top performer in the second quarter, sustainable funds faced headwinds in their effort to outperform their peers. However, according to Morningstar analysis, ESG stock selection was key to strong performance.

Weight of Energy Sector in ESG Managers Compared to Conventional Managers

Source: Morningstar

With the energy sector being the top performer in the second quarter, sustainable funds faced headwinds in their effort to outperform their peers. However, according to Morningstar analysis, ESG stock selection was key to strong performance.

The better relative performance of sustainable funds so far this year derives mainly from their focus on companies that have stronger ESG profiles and face lower levels of ESG risk. It helps make the case that investing with an eye toward how a company addresses material ESG risks and, more broadly, how it manages all of its stakeholders, can produce better returns than those of conventional funds, especially during periods of market and economic turmoil. However, this does not mean that sustainable funds will consistently outperform or that all sustainable funds will outperform conventional funds. Analyzing and investing in an ESG manager involves the same due diligence process as investing in conventional funds.

Passive ESG options also outperformed the S&P 500 Index during the second quarter and on a year-to-date basis.

Passive Large Blend ESG Investment Options and the S&P 500

Source: Morningstar

ESG managers lost less, on average, than conventional managers in the recent down market. Down-capture ratio is less than 100, indicating better relative performance in declining markets.

1-Year Down-Capture Ratio

Source: Morningstar

An increasing number of studies from academia and the asset management industry have shown that ESG investing does not necessarily mean sacrificing returns. The link between ESG investing and performance has been either positive or neutral (4). In regard to year-to-date performance, responsible investing factors have significantly outpaced non-ESG indices, while also reporting a lower amount of volatility (5).

Challenges in ESG Investing

One of the challenges in ESG analysis is that ESG metrics are not commonly part of mandatory financial reporting, though companies are increasingly making disclosures in their annual report or in a standalone sustainability report. Numerous institutions are working to form standards and define materiality to facilitate incorporation of these factors into the investment process. While these examples can often be measured (e.g., what the employee turnover for a company is), it can be difficult to assign them a monetary value (e.g., what the cost of employee turnover for a company is).

Investment managers use either proprietary data, third-party data, or a combination of both, in the ESG investment selection criteria. Sometimes third-party data for ESG scores for a specific company can be different among the data providers, complicating the comparisons for ESG metrics across the investment funds.

Another important challenge for ESG investing is the recently proposed rule by the Department of Labor (DOL). In June of 2020, the DOL issued a proposed rule indicating the DOL’s growing concern that market trends emphasizing the non-economic benefits of ESG investing may lead ERISA plan fiduciaries to make investment decisions for reasons other than maximizing returns for plan participants. The proposed rule appears to create stricter limits for ESG funds in retirement plans and confirms that an ERISA fiduciary’s duties of prudence and loyalty are satisfied where the fiduciary has “selected investments and/or investment courses of action based solely on their pecuniary factors and not on the basis of any non-pecuniary factor.”

The proposed DOL rule makes it clear that the need to be able to explain and document how ESG considerations will contribute to investment goals is greater than ever. Comments on the proposed rule were being sought for 30 days following its issuance in June. During this period, the Department of Labor received more than 1,500 comment letters from the industry, with many taking issue with the proposal.

The Future of ESG in Retirement Plans

There will be more to come from the DOL on ESG investing in retirement plans. However, the increasing prominence of ESG in investment decisions has become significant across the industry. On the supply-side, an increasing number of portfolio managers are considering ESG factors in their portfolios. On the demand-side, 85% of individual investors expressed interest in sustainable investing in 2019, up 10 percentage points from 2017 (6). ESG interest is even greater for the Millennial Generation, and with the Greatest Generation wealth transfer, it could mean significantly more assets flowing through to ESG investments. Approximately $30 trillion of wealth will transfer from Baby Boomers to 75 million millennials over the next few decades (7).

The sustainable funds universe grew to 303 open-end and exchange-traded funds in 2019 (8). The recent launch of passively-managed ESG target date funds by the world’s largest and one of the most influential asset managers will continue the push to bring U.S. sustainable fund fees down. The recent outperformance of sustainable portfolios and increasing demand from investors contributed to strong momentum of flows into these strategies. Given all of the circumstances, the need for higher-quality, low-cost ESG funds has never been greater.

  • (1) Morningstar Sustainable Funds Continue to Rake in Assets During the Second Quarter
  • (2) CFA Institute
  • (3) Morningstar Sustainable Funds U.S. Landscape Report
  • (4) S&P Dow Jones Indices: DSWESG outperformance: Anomaly or Long-term Trend?
  • (5) ISS: The Screened and Prime Series: ESG Attributes and Market Returns During the Pandemic
  • (6) Morgan Stanley Institute for Sustainable Investing: Sustainable Signals -- The Individual Investor Perspective (2019)
  • (7) Accenture: The “Greater” Wealth Transfer – Capitalizing on the Intergenerational Shift in Wealth, 2012
  • (8) Morningstar

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

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