Follow the money. That common-sense advice guides investigative journalists and criminal prosecutors looking for bad guys. It's also a good compass for investors and economists trying to separate fads from trends with staying power.
So when President Donald Trump announced the U.S. withdrawal from the Paris climate accord, some observers predicted slowing in the growth of investments guided by environmental, social and governance (ESG) considerations. The calculus in part was that lifting Obama-era climate rules would unburden fossil fuel companies and lessen the attractiveness of alternative energy stocks, for example. While the economics of coal and oil vs. natural gas, wind and solar will ultimately decide which industries and stocks are a better investment, so far, the opposite has occurred. From January to July of this year U.S.-based retail ESG funds and ETFs saw net inflows of $3.5 billion, topping the $2.6 billion in inflows for all of 2015 and the industry is on a pace to top the record $4.9 billion of inflows for 2016.
Lisa Woll, CEO of the US Sustainable Investment Forum (SIF) is not surprised. "We're going to see even more of what we've seen for the last decade" in the growth of ESG investing, she said. Without any "national framework" addressing environmental issues, Woll predicts more focus on "green focused investing, clean energy, clean technology addressing climate" and investors will follow.
Globally, $22.9 trillion of professionally managed assets are held under some form of "socially responsible" investing strategy, up 25 percent since 2014, and now represent 26 percent of all professionally managed assets as reported by the Global Sustainable Investment Alliance. In the U.S., ESG factors explicitly incorporated into investment analysis and decisionmaking apply to $8.7 trillion in assets, or nearly 22 percent of all professionally managed assets and have grown 33 percent in two years, according to SIF. And the market in the U.S. could grow even faster. Recent changes at the U.S. Department of Labor enable retirement plans to consider ESG factors, something that had previously been prohibited.
A facilitator fueling the growth is greater standardization of how the market measures ESG practices. These factors cover a variety of issues and can range from frequency of environmental violations to the ratio of CEO pay to the average worker. Long viewed as a "niche," boutique research houses specializing in scoring companies based on their ESG practices are being gobbled up by larger firms such as S&P Dow Jones Index and Morningstar Research and a common set of definitions is emerging. In recent years, major players such as BlackRock, State Street Global Advisors and Goldman Sachs have launched or acquired ESG investing capabilities.
John Hale, who writes about ESG investing for Morningstar, said advisers and asset managers are adopting an ESG screen to their investment process for four reasons. Differentiating themselves and building deeper client relationships based on a client's values is part of the equation. The move also meets growing demand, particularly among millennials and women, for some ESG overlay to their investment portfolios.
But Hale said investment analysis is also playing a part. An ESG screen is increasingly viewed as good risk management, and Hale points out that large asset managers like State Street Global Advisors and BlackRock, who primarily manage passive funds, are urging companies to focus in their public disclosures on material risks to their business posed by climate change.
Barron's recently published its second annual ranking of the top sustainable mutual funds, identifying 203 large-cap actively managed funds with assets exceeding $300 million whose ESG scores ranked above the S&P 500 index average. And 37 percent of those funds outperformed the benchmark S&P 500 over the previous 12 months, compared with 28 percent of funds in the large-cap category that beat the S&P. Barron's used Morningstar's database of more than 35,000 funds screened across more than 100 ESG criteria applied to each company in their portfolios.
Looking underneath the numbers really shows how mainstream ESG investing has become. Only 17 out of 203 of funds in the Barron's ranking advertise themselves as ESG funds. The majority received high ESG scores as a byproduct of their own investment processes. The implication is clear. Some part of investment managers' risk analysis seems to be screening informally for ESG principles so the impact of ESG criteria on investment decisions is arguably much larger than reported.
Why is this? Barron's provides one clue to investor behaviors. Pointing anecdotally to the recent experience of Equifax (EFX), Valeant Pharmaceuticals (VRX) and Volkswagen (VOW3) all scoring low across a variety of ESG criteria, they argue ESG-alert investors would have steered clear of all three before their highly publicized missteps and steep stock plunges.
Brad Allen is a freelance journalist and former investor relations executive for companies including Imation Corp. and Cray Research. His e-mail is brad@bdallen.com.
