Reality

ESG is already in the mainstream – and may well represent the future of investing.

The US Forum for Sustainable and Responsible Investment (USSIF) estimates the total US-domiciled assets under management using sustainable investing strategies grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the start of 2020, an increase of 42 percent. This represents 33 percent, or one in three dollars, of the $51.4 trillion in total US assets under professional management.⁵ While we take this number with a grain of salt given it is based on self-reporting by money managers, we do believe that the data is directionally accurate. Those money managers surveyed by USSIF cite client demand, risk management, and alpha potential as the top reasons for incorporating ESG in their decision-making processes.

While ESG might feel nascent in some areas of the world, there are examples in the US, Europe, Asia, and elsewhere that point to its importance going forward. For example, nations across the globe are establishing frameworks for sustainable finance. Major financial organizations such as the London Stock Exchange are focusing on sustainable finance offerings, and large institutional asset owners and asset managers are forming sustainability-focused coalitions, bringing together trillions of dollars to engage with companies, industries, and policymakers on these topics. For example, Climate Action 100+ is an investor initiative engaging the world’s largest corporate greenhouse gas emitters to encourage them to take action on climate change. To date, more than 370 investors with more than $35 trillion in assets under management have signed on to the initiative. We believe that ESG may become more the norm in investing as sustainable finance infrastructure improves, market penetration of ESG-focused products increases, and traditional asset managers integrate ESG factors across a larger portion of their assets.

Reality

We believe there is a genuine shift toward more sustainable investing. But to be clear, the level of ESG integration and intended outcomes vary from manager to manager.

While we believe that an authentic change of mindset is occurring industry-wide, understanding a manager’s history of implementing ESG – their approach, research quality, resources, and investment philosophy – is very important. You can’t rely on labeling or marketing positioning alone.

For example, not all asset managers that incorporate ESG have a goal of creating positive environmental or social change. Some only use a handful of ESG factors in their fundamental analysis, or only exclude certain stocks such as those of tobacco companies.

Reality

A growing number of investors are expressing interest in ESG solutions – but they might not know to ask for them.

There is plenty of evidence showing that investors are interested in sustainable investing – and it’s not just Millennials. According to our research, 75% of US workers believe it is important to make the world a better place while growing their personal assets.⁶

Despite the fact that ESG is a trending topic in the financial industry today and that we are witnessing an increasing preference for these strategies, we believe many investors are not aware that ESG investing strategies exist, let alone are available to them. This can hold true even in demographics where a higher level of awareness might be expected, such as among women and Millennials. Many clients may not be convinced of the potential benefits of sustainable investing until they understand the implications for their portfolio. Follow-up conversations and information on ESG investment opportunities – including potential performance and risk implications – remain imperative.

Reality

ESG assessment, in addition to traditional analysis, may provide a clearer picture of the risks and opportunities facing an investment in a particular company.

As politics and demographics evolve in meaningful ways worldwide, the market may be underestimating long-term environmental, social and technological innovation potential and underappreciating ESG risks. We believe that taking a long-term view of businesses and integrating ESG into investment decision-making may lead to better long-term investment results. There have been many academic and industry studies that suggest that ESG quality is correlated with financial outcomes.

For example, a 2019 MSCI study⁷ demonstrated how ESG quality can impact stock performance, risk, and valuation. It showed that companies with stronger ESG profiles typically exhibit higher profitability, lower frequency of severe drawdowns, and lower systematic risk. The study’s results also exhibited the limitation of traditional valuation models that don’t appropriately account for all the risks that companies face today.

Reality

As with any style of investing, there are no performance guarantees, but an approach that aims to fully integrate ESG risks and opportunities has the potential to outperform.

Perhaps one of the most pervasive myths about ESG strategies is that investors can either invest sustainably, or seek competitive returns over time, but not both. Historically, socially responsible investment strategies were focused on excluding “sin stocks” and other controversial businesses but stopped there. As a result, this exclusionary approach may have underperformed the broader market. Moreover, other factors play a role in performance outcomes, such as manager skill. However, many managers today view ESG and sustainability factors as pathways to idea generation and risk management that have the potential to result in better financial outcomes for their clients.

Reality

ESG strategies and analysis can be consistent with the crucial fiduciary responsibilities of many financial professionals.

Natixis Investment Managers fully supports the Department of Labor’s latest guidance to ERISA fiduciaries on ESG and including ESG-themed options in retirement plans. In the process of evaluating what is in the best interest of the investor, we believe it is important for financial professionals to consider ESG factors along with all other material factors that may impact an investment’s risk/return potential.

We consider ESG assessment as one of the many ways to properly value securities and to identify sustainable businesses that have strong management teams and can create long-term value for shareholders. In retirement plans, ESG-themed options may sit alongside traditional options in the same asset class or style box and, if appropriate, can replace those traditional options.

Reality

ESG is not a separate asset class. ESG-focused offerings are available across asset classes and investment styles. ESG products may serve to complement or replace products already in your lineup, or may be used to build 100% ESG-aligned portfolios.

Because ESG investing is not an asset class or a separate style of investing, financial professionals do not necessarily need to carve out a separate portion of the portfolio for ESG strategies. They may be considered a core part of a portfolio, or a satellite component, depending on what makes sense given the particular client and the particular ESG product option.

When considering large-cap equities or municipal bonds, for example, you wouldn’t consider only the labels of available strategies. We believe the same should be true of ESG investing. Instead of focusing on the ESG label, look at how the manager implements the strategy, the strategy’s motivations, the level of ESG integration and the strategy’s characteristics and performance. Do the same due diligence you would for any other potential portfolio component. An ESG-focused international equity fund may be used in a portfolio in the same way a traditional international equity fund would be, while providing the added benefit of sustainability mindfulness.

Reality

Many ESG-focused strategies align very well with a variety of exclusion and inclusion criteria.

We understand that individual clients may express very specific or seemingly restrictive environmental or social criteria – one may be solely focused on gender equality issues while another may have zero tolerance for fossil fuel exposure. However, there are many approaches today that can address a diverse range of desired outcomes, from faith-based investment criteria to promoting investment in renewable energy. It may require a deeper conversation about the approaches used and how they ultimately align with specific criteria. Asset managers like Natixis are here to help in these discussions. Additionally, for clients more interested in individual exclusions, there are customized ESG screening options available via separately managed accounts and direct indexing strategies.

Reality

The exclusion of “sin stocks” is more representative of the early days of socially responsible investing – many of today’s approaches seek informed analysis of investment risks and opportunities.

While excluding tobacco, alcohol, and contraceptives may be a preferable investment approach for a religious institution, it may not work for everyone. There are many different ESG approaches available to investors today. Rather than focusing on exclusion alone, many implement a more affirmative approach to security selection – seeking to invest in companies with stronger overall ESG profiles and companies whose missions are directly connected to long-term sustainable development trends. ESG analysis can also be used to better understand potential investment risks and opportunities. For example, the ways in which a given company considers issues such as energy efficiency, innovation, and demographic trends can inform their long-term business outlook.

Reality

While no universal ESG standard exists, sustainable investing protocols have evolved markedly. There are a number of ways to address client concerns about determining what investment strategies are ESG – and what type of ESG approach those strategies take.

Organizations such as Morningstar⁸, MSCI Inc.⁹, and the Forum for Sustainable and Responsible Investment (USSIF) have worked to consolidate and codify ESG product labeling and scoring approaches. The continued efforts of these organizations to label and score funds on ESG-related metrics has helped to improve the classification of sustainable investment strategies. Some, for example, score funds based on the ESG characteristics of the underlying companies. In this case, they are not making a determination about the approach the manager is taking, but aggregating the characteristics of the underlying holdings. MSCI and Morningstar also offer a view into whether managers have an intentional ESG mandate.

Ultimately, we believe it’s best not to take any categorization, label, or rating at face value and instead try to understand a manager’s investment approach and the extent to which ESG considerations are a part of their process. Just as important is determining what type of approach may work for an individual client.

Reality

Every portfolio has impact – whether positive, negative, or both – and there are methods to measure this.

Let’s start by acknowledging that any investor would be hard-pressed to find a large public company that operates in perfect harmony with ESG ideals. It follows that one would be hard-pressed to find a perfect, 100% impact-oriented portfolio consisting of equity or fixed income securities of large public companies. Nonetheless, ESG investing shouldn’t feel like a fruitless exercise. We advise against allowing the pursuit of perfection to impede progress. While it can be difficult to get clients on board with this notion, particularly if they are especially ESG-minded, explaining the manager’s rationale for owning particular companies – both from a financial and a sustainability perspective – can be persuasive.

When it comes to measuring environmental and social impact, certain metrics are easier to come by. For example, carbon footprint and gender diversity stats are readily attainable and comparable. Product and business involvement is also easily identified. Beyond that, there is more work being done by some asset managers and research firms to assess companies relative to the UN Sustainable Development Goals (SDGs) as a means of measuring sustainability impact. For example, do the company’s products, services and behaviors align with the achievement of the UN SDGs or do they present risks? Products and services can be linked to the SDGs and then a revenue-based approach may be used to measure exposure to them.

For instance, take a wind turbine manufacturer whose practices promote resource efficiency in the manufacturing process, while simultaneously promoting employee well-being, ethical supply chains, and strong community relations. Not only are the company’s products and source of revenue (wind turbines) contributing favorably to the achievement of SDG 7 and 8 (Affordable and Clean Energy and Climate Action, respectively), among others, but their business practices also do not negatively impact other goals. In this case, it can be argued that the wind turbine manufacturer creates positive environmental impact.

Reality

Organizations such as the Sustainability Accounting Standards Board (SASB) have created reporting frameworks and introduced voluntary reporting guidelines and standards that have improved the transparency and comparability of corporate reporting. Many third party ratings and research providers such as Sustainalytics have also helped to gather and assess ESG data for investors.

The reporting and data available to investors regarding ESG factors and metrics continues to improve. In 2017, more than 85% of S&P 500^® Index companies produced sustainability reporting, compared to just 20% in 2011.¹⁰ Additionally, there has been an uptick in the number of public companies reporting on material ESG risks and trends in their required SEC disclosures and speaking to these issues on quarterly earnings calls. Organizations such as Global Reporting Initiative and the Task Force on Climate-Related Financial Disclosures (TCFD) are helping businesses better understand the risks they are exposed to and helping them measure and communicate this to investors.

Asset owners and asset managers are increasingly relying on third party reports and ratings to assess and measure company ESG performance. This assessment and measurement also often forms the basis of investor engagement with companies on ESG matters. Many providers encourage input and engagement with their subject companies to improve or correct data where applicable.

ESG data providers play an important role by gathering and assessing information about companies’ ESG practices and then scoring those companies accordingly. The development of these ratings systems has helped to nurture the growth of ESG investing by giving asset owners and managers an alternative to conducting such extensive data collection and diligence themselves. Despite the valuable contributions these data providers have made in advancing ESG investing globally, it’s important for asset owners and managers to understand the inherent limitations of this data, as well as the challenges of relying on any one provider, as report and ratings methodology, scope and coverage vary greatly among providers.