Is ESG investing going mainstream?

It is still easy to find naysayers of investing based on environmental, social and governance factors, but those critics who once held the high ground of quantitative and rational analysis are starting to feel the ground slowly crumble beneath their feet. Old concerns about the limited number of ESG funds and drag on performance from strict screens are giving way to appreciation for the added intelligence ESG factors reveal about the future strength of any investment. "ESG is rooted in improving the investment outcome, rather than some other goal which may not be investment-oriented, and that's where we're seeing some convergence," said Chris McKnett, head ESG strategist at State Street Global Advisors. The proof is that true believers — the ranks of which go well beyond the tree-huggers and do-gooders that pushed the agenda in decades past — are now showing up in such traditional firms as State Street Global Advisors, BlackRock Inc. and Putnam Investments. Those firms are joined by ESG-focused money managers in realizing the value of scouring the data. "In general, companies with the strongest records on employee relations and environmental sustainability, for example, often have better financial performance over the long run than those with the weakest records," said Sonia Kowal, president of Zevin Asset Management, a $600 million firm that exclusively builds ESG portfolios. "Given this, why wouldn't you use this information advantage when looking for investment ideas?"

Not your grandfather's ESG

Strategies around "responsible investing" have broadened since the early days of simply rejecting certain firms or industries. "Screening out companies was your grandfather's ESG, and it was a real blunt tool," said Erika Karp, founder and chief executive of Cornerstone Capital Group, which has $1 billion in ESG assets under management. "Screening out companies in a vacuum will lead to underperformance." But today there is a serious reassessment going on in the financial services industry and broader investing community about what ESG ratings can illuminate about a potential investment. Money managers are rapidly expanding research and expertise of ESG factors as tools for analyzing risks and opportunities. "We believe looking at ESG factors can add alpha over time, so it's just good credit research," said James Rich, a portfolio manager at Aegon Asset Management, which manages $375 billion in fixed-income strategies.

Aegon is unique in that it isn't necessarily holding up any kind of ESG or socially responsible investing banner. It is just embracing the potential of the flood of new ESG data and analytics being gathered and incorporating it into investment strategies. Instead of looking at ESG factors as a soft and vague measurement of what kind of corporate citizen a company is, the mounting data related to environmental impacts and social issues are increasingly being measured right alongside such things as cash flow and earnings on the balance sheet.

'The whole picture'

"If you're not looking at ESG factors, you're not looking at the whole picture," Ms. Kowal said. She cites carbon emissions as a classic example of where ESG factors can expose risk and opportunities. "Companies that are factoring in the cost of carbon emissions are ahead of the curve," Ms. Kowal said. "Do you really want to hold a carbon-intensive company that's not thinking about this?"

But many financial advisers still look at ESG investing through an old lens, according to the InvestmentNews Research white paper "The Rise of ESG Investing," sponsored by Calvert, which included a survey of 475 advisers last July. Two of the top reasons given by advisers for not using ESG investments were limited investment opportunities (29%) and poor or limited returns (22%). The latest data from US SIF, The Forum for Sustainable and Responsible Investment, show that at the end of 2016, $8.72 trillion in assets in the United States qualified as social and impact investing. That total is up from less than $7 trillion at the end of 2014 and roughly $4 trillion at the end of 2012. Lipper, which defines the category as socially responsible investments, counts 535 SRI mutual funds and 28,813 non-SRI funds. As to competitive returns, this year through Jan. 25, the SRI equity funds averaged a 7.73% gain, compared to a 6.64% gain for non-SRI equity funds. Last year, the SRI and non-SRI equity groups were a virtual tie, at roughly 21.7%. And in 2016, SRI funds averaged 8.81%, while non-SRI funds averaged 9.59%. Not everyone is satisfied with relying on recent performance. Michael Palazzolo, owner of Fintentional — an advisory firm based on hourly and retainer fees — is decidedly not sold on ESG strategies. "I think it has to be money you are willing to lose," he said. Even though his clients range in age from 21 to 62, and recognizing that younger investors are among the biggest fans of ESG strategies, Mr. Palazzolo said he isn't seeing any demand from clients. "I've looked into ESG, but it's not a high priority," he said. In fact, 58% of advisers in the InvestmentNews survey said a main reason they do not use ESG investments is because their clients are not interested in weighing such factors.

Almost half of advisers, however, view ESG investing as a long-term trend and expect that within three years, about a third of their clients will be allocated to ESG strategies, up from about 20% now, according to the survey. Mitchell Kraus, a partner at Capital Intelligence Associates Inc., is already seeing such a change in his firm. "About 30% of our clients are invested in ESG strategies, but about 70% of our new clients are investing in ESG," he said. "It's the fastest-growing part of our practice." Mr. Kraus, whose firm manages $200 million, has been writing a blog on ESG investing for about six years. He agrees that analyzing such factors "brings an additional layer of research to help evaluate potential investments." Mr. McKnett of SSGA envisions a not-too-distant future where the "nontraditional drivers of return" from ESG factors — such as managing carbon emissions or focusing on boardroom diversity — become known as the primary drivers. And that's when financial advisers will have to take notice. "More and more investors are sort of flipping it on its head, saying this is part and parcel of being a fiduciary, and we must consider all factors," he said.

'Managing risk'

State Street Global Exchange, which has $33.1 trillion in custody assets for institutional investors, has created an institutional investor product suite with technology firm TruValue Labs that incorporates artificial intelligence. "Often when you talk about this space, it has a political bias," said Mark McDivitt, head of ESG solutions business at State Street Global Exchange. "But that's not what ESG is; it's how to do a better job at managing risk." In January, Putnam Investments registered to convert two mutual funds into "sustainable" strategies. "We're still in an era where a lot of the data is backward-looking," said Katherine Collins, who joined Putnam last year as the head of sustainable investing. "But if you're an investor, why in the world would you not want to look at this set of ESG factors? There is a lot of cool stuff happening with the data. It is becoming more structured, and the blank spots are starting to fill in as more companies start to report this information." But there's likely a long road ahead before more of the advice industry accepts ESG investing, according to Ms. Karp of Cornerstone Capital Group, particularly because of an "ideological context that has politicized it." She explains very clearly, though, how that understanding is outdated. "ESG analysis is an investment discipline and an analytical methodology," Ms. Karp said. "I personally enjoy smoking, drinking and gambling, but my values don't matter."