As management consultant Geoffrey Moore has observed, "Without big data, you are blind and deaf in the middle of a freeway." Historically, that's been the most challenging part of investing using environmental, social and governance factors, but the data are getting much better.
Data replace opinions with knowledge, and it is increasingly clear that ESG data and ESG investing matter. Properly integrating ESG factors into investment decision-making can improve investor outcomes, especially for those with investment time horizons of longer than a few years.
While the traditional socially responsible investing mantra has been that ESG investing can help investors do well while doing good, an investment-centric take on that theme is that inattention to material ESG factors is risky for investors, just as it is risky for the planet and its residents.
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Responsible stewards of other people's money — fiduciaries — need to pay close attention to developments in ESG investing and objectively assess how and when to apply the growing body of knowledge in this area.
In 2018, the CFA Institute and Principles for Responsible Investment released a 177-page publication,
Guidance and Case Studies for ESG Integration: Equities and Fixed Income, that provides insights about how leading practitioners around the globe integrate ESG factors into their analysis of equities and fixed-income securities.
Importantly, the study introduced an ESG Integration Framework that formalizes a three-level approach to evaluate and apply ESG investment techniques: research (qualitative analysis), security valuation, and portfolio level analysis, construction and management. This is an indispensable guide to understanding how material, or investment-relevant ESG data can be used to make better decisions about securities selection and portfolio management in the context of investor needs and objectives.
As an important indicator of how rapidly ESG investing is evolving, S&P Dow Jones Indices launched
the S&P 500 ESG Index in January. Relying upon ESG data that are collected, scored and benchmarked by one of the most well-established service providers in the field, RobecoSAM, the index is designed to eliminate companies that carry low ESG scores yet closely track the industry composition and performance of the S&P 500. The index is intended to be used as a benchmark and as the basis for index-linked investment products.
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In terms of demand and performance, recent numbers are attention-grabbing. Morningstar tracks "sustainable funds" and ESG consideration funds (conventional funds that use ESG criteria in their investment decision-making).
The company's latest finding is that "sustainable funds attracted an estimated $8.9 billion in net flows in the first half of 2019, surpassing their $5.5 billion in flows for all of 2018."
Moreover, it noted that, "In the overall universe, about one-third of funds receive 4 or 5 stars [in the Morningstar rating system], about one-third receive 3 stars, and about one-third receive 2 or 1 stars. For these sustainable funds, the distribution is 43% in the top third, 38% middle third, 19% bottom third." One-, three- and five-year results are similarly positive for sustainability funds. Not surprisingly, the number of sustainability and ESG consideration funds is increasing.
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As demand for investment products that integrate ESG data grows, securities regulators around the globe are pressing publicly owned companies to provide more robust reporting.
The U.S. has trailed in the regulatory trend to provide investors with ESG information that is material to investment and proxy voting decisions, but on July 10th the House Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets held hearings on three pieces of proposed legislation to improve ESG disclosures. While the House may pass legislation, prospects for Senate approval are uncertain. Similarly, regulatory action by the SEC on ESG-related initiatives is unlikely under the current administration.
Even if legislation currently under consideration were to become law, as was noted in the testimony of James Andrus, investment manager for financial markets and sustainable investment at Calpers, it would only apply to publicly traded companies.
Mr. Andrus encouraged legislators to consider what can be done to foster better ESG disclosures in the nonpublic markets because "the majority of capital raised in the U.S. is now through so-called 'private' offerings, which do not have the disclosure obligations or investor protections that are the hallmarks of the public capital markets."
The reality is that the relentless pursuit of information drives demand in the direction of what works in practice. That is what appears to be happening in the ESG space. Legislators and regulators are lagging indicators of where demand is leading us.
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Blaine F. Aikin is executive chairman of Fi360 Inc. and CEFEX.
Register now for our inaugural ESG & Impact Forum Dec. 5 at the United Nations, where thought leaders, investment strategists and practitioners will gather to translate global ESG and impact investing perspectives into strategies that resonate with investors.
