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Ethical Capital: ESG Trends In Global Investment Research

Published on Jun 13, 2019

Impact investing, responsible investing and sustainable investing are buzzwords that refer to a growing trend in global investment research processes. Socially conscious investors are driving the integration of Environmental, Social, and Governance (ESG) factors into traditional investment research processes.

ESG factors analyze a broad range of behaviors and performance metrics of a company. Environmental criteria consider a company’s performance as a steward of nature, such as how it responds to climate change, disposes of hazardous waste, manages natural resources, or complies with environmental regulations. Social criteria analyze how a company treats its workers, ensures their health and safety, manages its supply chains, and whether it donates a percentage of its profits for the development of local communities. Governance factors aim to unearth whether companies have transparent and accountable corporate governance structures that foster trust and innovation. Erstwhile seen as only ethical screening for potential investments, ESG performance of companies is increasingly documented as having financial relevance.

The case for integrating ESG criteria into traditional investment research:

The current ESG investment research trend is preceded by the Socially Responsible Investment (SRI) movement, which primarily sought to screen potential investments based on ethical and moral criteria, such as by not investing in tobacco or firearms. There was not much of a financial case for incorporating SRI into traditional investment research back then. However, in recent decades, several trends have contributed to a steady shift in how traditional investment research is conducted, wherein ESG criteria is increasingly considered to have financial relevance.

ESG first began to be formally considered as relevant to investment research in 2005, with the release of a ground-breaking report titled “Who Cares, Wins.” The report, published by the UN and endorsed by major financial institutions, argued that embedding ESG criteria in financial markets leads to not only better-off societies, but also sustainable markets. Since the landmark report in 2005, ESG investing grew steadily, but greatly augmented in 2013 and 2014 when the first batch of studies successfully linked good sustainability practices of companies to good financial results. A recent study conducted by MSCI researchers found that high ESG ratings of companies were associated with lower tail risk, lower systemic risks, and higher profitability.

Global sustainability challenges, such as climate change, data security and privacy, regulatory pressure, unethical supply chains, and so on are all sources of risk that if not managed effectively can have significant financial impact on a company’s valuation and performance. Several studies have showcased that companies that have robust ESG practices are better equipped to deal with global risks and, as a result, experience lower capital costs and volatility. However, companies that perform poorly against ESG criteria experience higher capital costs and volatility due to greater risks of events such as worker strikes, fraud, or controversies. For example, Volkswagen’s diesel emissions scandal and BP’s 2010 oil spill led to billions of dollars in losses and significantly impacted the companies’ stock prices.

Given the current global context, incorporating ESG criteria in investment research can unearth sources of financial risk and conversely also determine the sustainability of investments. From an ethical standpoint, many investors recognize that ESG disclosures of “corporations are vital to understand corporate purpose, strategy, and management quality of companies”. By integrating ESG criteria, investors can avoid investing in companies whose practices indicate financial risk, or screen for companies that practice sustainability.

ESG trends in investment research:

UN-backed Principles of Responsible Investing (PRI), a voluntary initiative that has a mandate on including ESG factors in investment research, has garnered the support of over 1,800 signatories since its inception in 2006. These signatories represented approximately USD 89 trillion in assets under management (AUM) in 2018.

Following are some big trends in ESG investing to look out for.

At a global scale, Socially Responsible Investing (SRI) reached approximately USD 23 trillion in April of 2018. A large proportion of these assets were held in Europe and the US, with Europe holding about 50% and the US about one-third of those assets.
In terms of instruments of investing, 65% of all global ESG SRI were invested in fixed income instruments, whereas about USD 11 billion were invested in ESG exchange-traded funds (ETF).
In developed markets, especially in the EU and the US, ESG performance is increasingly linked to fiduciary duty.
According to the US SIF Foundation in 2018, assets worth USD 11.6 trillion were chosen as per ESG criteria in the US. This figure saw an enormous growth of USD 3.5 trillion in two years.
At the end of 2017 in Europe, EUR 236.7 billion of assets were invested in ESG equity funds, whereas EUR 97 billion was invested in ESG fixed income securities. Asset managers with ESG expertise have been getting greater volumes of business from insurers and pension funds in Europe.
Despite the major market share held by Europe and the US, China, Japan, Australia, and New Zealand have also been greatly contributing to the surge in impact investing.
As per McKinsey, integration of ESG in portfolio management is growing at 17% per year, calling ESG a “fast-growing market segment”.
Due to greater environmental, social, and political volatility in emerging markets, investing there can carry more risk. However, research suggests that emerging market portfolios that account for ESG risks are subject to a reduced level of tail risk, i.e. the risk of unlikely events causing catastrophic damage.

Impact investing had its roots in ethical arguments of the modest SRI movement, but in recent decades it has morphed into a market segment of sizeable proportions which not only incorporates ethics but also makes a case for the financial relevance of ethical and sustainable business practices. ESG investing is changing the way of traditional investment research, globally. Several mutual fund companies and brokerage firms now offer exchange-traded funds (ETFs) that integrate ESG factors. Giants such as Goldman Sachs, Wells Fargo, JP Morgan Chase, and other financial services companies have been disclosing their ESG approaches as well. With growing consensus that ESG factors have financial relevance, we can expect the world of investment research to increasingly incorporate ESG criteria into erstwhile traditional approaches focused narrowly on profitability only.

SG Analytics in the ESG space:

In the ESG research space, SG Analytics provides research services that gauge the sustainability impact of securities across multiple asset classes, as well as reputational risks of investments. We conduct this research by using both standardized ESG research methodologies and custom methodologies.
In the equity space, SG analytics has been conducting research on 13,000 to 15,000 stocks across multiple countries and sectors. We gauge ESG risks by studying company disclosures and NGO reports to understand the ESG performance of companies.
We also study the sustainability impact of securities in the US bond market, which is primarily for investors who are keenly interested in understanding the social impact of their investments. Fixed income ESG investment research space is relatively newer in comparison to ESG investment research of equities.
SG Analytics also provides thematic pieces to asset management firms and international NGOs.