This article has been written by Kaustubh Belapurkar, director of fund research at Morningstar India.
Overall, social consciousness has been rapidly increasing amongst the general population over the years; be it the recent Volkswagen scandal on emissions or the repercussions on the environment of the British Petroleum oil spill. Back home, we are all aware of the impact events such as the Bhopal Gas tragedy had on human life and the environment or the financial backlash due to poor corporate governance as in the case of Satyam Computers.
While these are issues we feel strongly about as a society, how many investors actually use these screens when making investment decisions?
Environmental, social and governance, or ESG, investing is one such popular mechanism for making socially responsible investments. ESG refers to the three main areas of concern that have developed as central factors in measuring the sustainability and ethical impact of an investment in a company or business. These areas cover a broad set of concerns increasingly included in the non-financial factors that figure in the evaluation of a company.
Traditionally, socially responsible investing was referred to as avoiding certain stocks or sectors which were viewed as detrimental to society in general. This has evolved over the years into the ESG investing concept. Instead of using screens, it favours using multiple factors to find best-in-class investments across a wide range of sectors.
ESG research empowers investors to make more informed choices and better align their money with their values, which is their right to do. It gives investors a louder voice to corporate leaders. Over time, the practice, which today is in its infancy, will evolve and become more sophisticated. In the process, it will lead to better behaviour and increased accountability. Having said that, it already is a powerful force that appropriately reflects investor rights. ESG factors offer portfolio managers added insight into the quality of a company's management, culture, risk profile and other characteristics.
Increasing evidence suggests that integrating ESG factors into the investment analysis and decision making may offer investors potential performance advantages over the longer term. ESG has become handy tool for investment managers that embrace ESG or sustainability factors as a means of helping to identify companies with superior business models. Globally, many managers tend to use ESG scores as a metric to gauge investment risk.
ESG scores can also be a proxy of management quality and an indicator of corporate governance. As we have seen with the local markets in the past, great businesses can go down due to dodgy corporate governance practices. Often when investors lose money, this is attributed to poor management of the risk posed by ESG issues. Additionally, social issues like labour unrest can have a significant impact on a company’s financial performance.
ESG issues can also be related to megatrends that can affect the performance of a company. Thus it is important to carefully study how a company is managing its ESG risks. In short, ESG research plays an important complimentary role to fundamental research.
Asset-management firms are showing more interest in sustainable investing.
In April 2006, the United Nations-supported Principles for Responsible Investment, or PRI, was launched with 100 signatories, representing $6.5 trillion in assets under management, committing to incorporate ESG factors into their investment analysis and decision-making process, to be active owners engaging with companies about ESG issues, and to report publicly on their activities and progress. Nearly a decade later, the number of signatories is nearing 1,400, and assets under management are nearly $60 trillion. Signatories include many large institutional investors, investment managers, and investment service providers. Among the more than 900 investment managers are 11 of the 15 largest in the world, including BlackRock, Vanguard, JP Morgan, Goldman Sachs, PIMCO and Franklin Templeton.
As active owners, they also engaged companies on broader issues of corporate social and environmental responsibility through proxy voting, filing shareholder resolutions, and importantly, direct engagement with management. Progress is more typically made in a lower-profile way through discussions with company management.
Europe has a large head start over the U.S. in ESG investing. According to the 2014 Global Sustainable Investment Review, 58.8% of European invested assets already are invested in a sustainable way, compared to 31.3% in Canada and 17.9% in the U.S. One of the reasons Europe is leading the way is the fact that European institutional investors see sustainable investing as part of their fiduciary responsibility.
By screening companies would investors lose out on profitable investment opportunities?
In practice, however, there is little evidence indicating a performance penalty for sustainable investing, particularly among mutual funds. It is also possible that sustainable investing can lead to outperformance because the consideration of ESG issues can point analysts to material issues that may not surface in traditional financial.
In 2014, researchers at Oxford (in a paper titled “How sustainability can drive financial outperformance”) analysed nearly 200 studies, reports, and articles on sustainability and found that at the firm level:
- 90% of the studies on the cost of capital show that sound sustainability standards lower the cost of capital of companies.
- 88% of the research shows that solid ESG practices result in better operational performance of firms.
- 80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices.
Morningstar launches sustainability scores
Despite all these positives, it is hard for advisers to assess sustainable investments and properly place them in a diversified portfolio. Morningstar’s sustainability scores are to help advisers do just that.
These scores will give advisers and investors the ability to compare funds based on how well their holdings are handling ESG risks and opportunities. They will allow investors to compare conventional funds with self-identified sustainable funds, as well as to choose funds based on whatever level of sustainability score they desire. The portfolio sustainability scores will help advisers and consultants evaluate funds as well as client portfolios and plan lineups.
The above column has been taken from the online publication of India Markets Observer. To see the outlook for various asset classes, perspectives on the industry, investing insights, and the entire list of contributors, click here.
