Responsible Investing Goes Mainstream

During times of market volatility, investors return to the mission of their investment portfolios. In a growing number of instances, this includes a focus on environmental, social and governance (ESG) principles.

In its infancy, responsible investing was primarily implemented as socially responsible investing (SRI) and was driven more by values — often religious or morally based — than by the pursuit of optimal risk-adjusted returns. Most investors who pursued SRI were able to justify the possibility of lower returns by their overriding motivations to “do good” and by their morality. Now, however, there is a growing sentiment that doing good and doing well don’t have to be mutually exclusive.

Responsible investing began as a way to avoid “sinful” or “wrongful” investments, such as alcohol or tobacco, by excluding them from a portfolio. Today, however, the focus is on companies that have embraced ESG principles (positive securities screening or “best in class”). These companies not only are often well managed, but they also enjoy more limited risk exposures relative to companies that have not adopted ESG practices. These strengths translate to greater growth and profit potential. In other words, these companies have a good chance to outperform their benchmarks in the long run.

In a joint review of 20 research studies on ESG factors, the United Nations Environment Program Finance Initiative and Mercer found half of the studies concluded that ESG factors have a positive impact on investment performance. Of the remaining 10 studies, three had negative conclusions and seven were neutral.

Two broad ESG stock indexes also indicate a positive impact. The Morgan Stanley Capital International (MSCI) World ESG Index and the MSCI KLD 400 Social Index (formerly the Domini Social Index, a well-established SRI index) both have performed on par with their broad-market, non-ESG counterparts over medium- and long-term time horizons with similar risk profiles and exposures. The results demonstrate that investing responsibly and achieving investment objectives are not mutually exclusive, particularly for investors biased toward a passive approach to portfolio implementation.

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Global Growth and Acceptance

Today, the shift toward a more inclusive approach has led to a boon in ESG portfolios as investors have found ESG factors have had a positive impact on corporate profitability. In 2002, ESG portfolios totaled $2.6 trillion; by 2010, assets in ESG portfolios hovered around $10.1 trillion globally. While ESG investing has grown steadily in the United States, it has increased exponentially in Europe, where ESG assets have grown by 85% in the past two years.

As responsible investing transforms — philosophically and tactically — it is becoming a more integrated step in the investment-screening process. A study of European corporate pension funds by Eurosif, a pan-European think tank, found 56% of the funds have ESG principles within their investment policy statements, and another 10% said they will consider adding ESG principles in the next year.

It’s hard to know the exact cause and effect of ESG principles on corporate performance. Do companies that embrace ESG principles already tend to be well managed and less exposed to certain risks? Or does the act of following ESG principles actually help to lower risks, which in turn can generate potentially higher profits and benchmark outperformance?

“By investing in companies that have addressed governance issues, as well as social equality, labor and environmental issues, you are mitigating some risk,” said John McCareins, senior program manager in the Client Solution Group at Northern Trust. “A company with good labor practices tends to have a lower risk of being sued, and one with a smaller carbon footprint could potentially face lower taxes in the future.”

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Managing Portfolio Risk

There are risks associated with an ESG portfolio. For example, an investor may forgo the potential returns from so-called “sin stocks.” However, this risk might be offset by a reduced exposure to the regulatory and legal factors that often accompany these stocks. In addition, some investors may be willing to accept the risk that comes from omitting certain sectors or securities in exchange for the opportunity to pursue potentially higher returns from leading-edge ESG stocks. For example, an ESG investor might benefit from investing in a stock that is viewed as responsibly sustainable and has a unique economic opportunity, such as a “green energy” stock.

“By excluding a tobacco stock, for example, you are not fully exposed to the entire market, therefore missing the entire opportunity set,” said Mamadou-abou Sarr, senior product specialist at Northern Trust, London. “However, if you are committed to sustainable investing and bringing long-term value to your shareholders, it’s a risk you’re willing to manage.”

Tracking error, or the extent to which a portfolio varies from its benchmark when a stock is overweighted, underweighted or omitted from the portfolio, is a concern for actively managed portfolios or those passively managed that incorporate negative screening when compared to a standard market benchmark. Tracking error, however, can be managed. For example, when applying a passive approach mirroring an ESG benchmark, which in many cases are designed as proxies for standard market indexes, the remaining companies can be “optimized” to create a portfolio that minimizes tracking error relative to a standard benchmark, Sarr said. For the end investor, passive ESG strategies might represent a viable means to obtain low-cost beta exposure to ESG themes with minimal tracking error.

“This is a major global trend. As investors integrate a focus on accountability for environmental, social and governance practices, we’ll see greater success for those companies that embrace ESG principles,” McCareins added. “If ESG criteria become the norm rather than the outlier, I believe we’ll see broadly improved corporate behavior and overall economic growth.”

After all, asset owners, investment managers, corporations and investors all own a slice of the global economies and have a vested interest in mitigating potential risks and shocks, financially, socially, or climate-related, that can derail productivity, growth, and development. The adoption of responsible investment practices is one step toward mitigating those risks.

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