ESG funds performed very well in 2020 (see chart below). There has been ongoing debate by investment researchers on whether environmental, social and governance (ESG) investment brings extra returns, or “alpha” to portfolios, above traditional funds and benchmark indices. Even if you don’t believe in the “alpha” argument for ESG investing, no investor should ignore the mainstreaming of ESG. In this blog, I explain the two reasons why.
SDWD - iShares MSCI World ESG Screened ETF
SUWU - iShares MSCI World SRI ETF
INRG - iShares MSCI Global Clean Energy ETF
ESG issues unite many different stakeholders
First, despite possible difference in interests and political positions, many stakeholders and parties are aligned on ESG related issues. This alignment of interests means that governments, investment professionals, investment managers, companies and end investors are all doing something to make sure ESG issues are being considered. More investors are demanding their capital be invested in companies with high ESG credentials. In the past, such demand would have resulted in many providers jumping on the bandwagon, launching products with just the label but no real process. Not now - partly because of pressure from other stakeholders like governments and regulators, and partly – and importantly – because these days investment professionals genuinely believe in ESG investment (see this previous blog ).
Even if you do not require ESG measures to be explicitly included in your fund managers’ security selection process, they should still consider the negative impact of ESG issues on the companies they invest in. According to Bloomberg, Moody’s estimates that over $7.2 trillion of debt issued by companies has “high inherent exposure to physical climate risks”. This is not a trivial amount!
More positive ESG developments expected in 2021
Secondly, in 2020, we saw many ESG related initiatives launched by different authorities and organisations. Some critics will say that there are too many. But we think this reflects how seriously different stakeholders now take ESG.
An urgent requirement is for standardisation in disclosures by companies, which is covered by a few initiatives and should make further progress in 2021. Standardisation in naming products and strategies is also important. An example is the terminology of “carbon neutrality”, where ambiguity may result in unintended consequences which some ESG investors may find objectionable (see here ). There have been different standardisation proposals on naming of ESG products by different industry bodies in 2020. We expect them to converge in 2021, resulting in better communication to end investors on the investment objectives and investment processes of their ESG portfolios.
From March this year, European fund management firms need to comply with the EU sustainable financial disclosure regulations. These regulations require fund management firms to provide information on ESG risks to all portfolios, not just ESG funds (which need separate statements of evidence). The regulations allow fund managers to self-certify on these disclosures, so there could still be a risk of “greenwashing”. But it seems that fund management firms are treating compliance to these regulations seriously. The Financial Times reported recently that some firms have devoted the same number of people in implementing these regulatory requirements as with the implementation of MiFID II in 2018 (which, as many readers will remember, involved a lot of people).
Mainstreaming of ESG
These two reasons highlight that ESG is becoming embedded in the investment world. I call this trend “mainstreaming”. Even if you do not invest in ESG funds, ESG measures will be integrated in many investment managers’ investment process for all funds. An investment manager can no longer afford to ignore possible negative impacts of ESG issues on the long term financial and business performance of companies. Therefore, investors and their advisers should carefully monitor how their fund managers are tackling ESG issues.
This blog is based on Tricio’s view on the mainstreaming of ESG as discussed in our January 2021 edition of Tricio Monthly Insights. For a free copy, professional investors only need to email us at firstname.lastname@example.org.
James Chu CFA
Head of Investment Solutions
2 See the jargon buster section written by our Chief Strategist, Gerry Celaya, in Tricio’s January Monthly Insights. Professional investors can contact us at email@example.com for a copy.