Assets in sustainable funds now exceed $1 trillion. This means, more than one-quarter of assets under management globally are being invested based on the premise that ESG (environmental, social, and governance) factors can materially affect a company’s performance and market value.
Previous misconceptions, primarily the myth that sustainable investing automatically leads to lower returns, have long since been dispelled. The techniques, investment strategies, reporting, screening, selection processes, and management of ESG funds have undergone a massive wave of innovation, only to be innovated all over again.
In the last 20 years, the question being asked about investing in sustainables has changed from ‘Why?’ to ‘Why not?’.
The roots
The early stages of sustainable investing were almost entirely composed of ethical or moral assessments of business activities. Individual investors were simply using negative screening (avoiding material ESG risks) to avoid certain companies or sectors considered to be unethical. For example, an investor would leave Philip Morris out of her portfolio because of the health drawbacks caused by smoking, or avoid the alcohol industry altogether. At this point, ethical considerations often outweighed financial returns and the universe of available securities was restricted because of the “exclusion” lists.
Until the early 2000s, this was the norm, with almost zero innovation in the space. Then, good corporate governance was linked to long-term performance. Investors, and fund companies, began to engage more directly in linking material ESG factors and created portfolios based on criteria.
Consider if BP would have never spilled oil. If the company had been more focused on protecting the environment, would it have done a better job of preventing oil spills, leading to higher long-term returns? This was the sort of question that began being asked.
In the last 20 years, a consistent drive towards ESG considerations has become widely adopted by mainstream institutional investors. This adoption provided a significant tail wind to ESG-conscious companies, pushing their relative valuations higher and increasing total returns.
More recently, the reality of climate change has pressured policymakers to tackle many of the same issues long-standing ESG investors have opposed. As this reality has sunk in, countries, companies, and even large asset managers (pension funds, insurers, banks) are pledging to accelerate the transition into a low-carbon world.
All of this translates into dramatically increased demand for ESG-focused investment solutions.
The road ahead
While there has been an explosion of new products available, there are countless challenges yet to be solved: Inconsistency in disclosure, missing data, lack of comparability, and the idiosyncratic nature of the entire landscape have consistently proven to be the most menacing.
Still, mainstream adoption means a host of new parties all working on the same problems. Historically speaking, this type of global focus has led to rapid innovation.
The entire investment industry recognizes the importance of incorporating ESG considerations into analysis. These considerations provide a more comprehensive assessment of risks and opportunities, a holistic approach to investing. If the investors are focused on it, one can be sure that every company vying for capital will do whatever they can to shore up any possible ESG-related vulnerabilities, leading to a safer and greener world.
Despite decades of evolution, the landscape of sustainable investing is just now beginning to hit its stride. Complex global issues will continue to provide investors – both institutional and individual – significant challenges as well as opportunities.
The future, though far from fully realized, is bright.
