April 18, 2018
This excerpt, taken from Balentine’s 2018 Capital Markets Forecast, provides an overview of environmental, social and governance (ESG) investing, including the drivers of ESG demand, fiduciary duty and the investment consequences of ESG integration, as well as Balentine’s plans as it relates to ESG implementation. Want to learn more? Don’t miss Balentine’s full 2018 Capital Markets Forecast, our signature research piece that serves as the foundation of our investment process.
ESG investing has become a colloquialism for any form of investment strategy that incorporates certain “sustainability” factors or ethical considerations into the investment decision-making process. In its truest sense, ESG is simply a set of criteria—environmental, social, or governance—that businesses and investors can use to evaluate potential financial endeavors in a stakeholder-friendly context. Using ESG criteria as inputs, investors engage in socially responsible investing (SRI) and businesses engage in corporate social responsibility (CSR). For simplicity’s sake, we will use “ESG investing” as an all-encompassing term for both SRI and CSR, with criteria shown in Figure 5.
Ethically motivated or “values-based” investing is nothing new; with religious underpinnings, ESG investing has been practiced in the West since at least the mid-17th century. The Quakers prevented followers from investing in companies that profited from slavery or other such activities deemed unethical, while John Wesley and his Methodist followers sought to gain all they could without hurting their neighbors. The creation of the Sullivan Principles, encouraging signatories to operate their businesses in a manner that treated all employees equally, laid the groundwork for a broader institutional divestment from South African businesses in the early 1980s, fueling the social angst that helped bring apartheid to an end. The Chernobyl disaster and the Exxon Valdez oil spill further propelled public demand for greater corporate culpability, and a full-scale ESG movement took root in the late 1980s.
Drivers of ESG demand
What began as a European investment phenomenon is morphing into a genuine institutional overhaul. A 2016 survey commissioned by Natixis Global Asset Management found that 91% of institutional managers claim to incorporate ESG criteria into their investment analysis process. Institutional efforts are largely focused on risk management, with a recent CFA Institute survey finding that, of those investors making use of ESG criteria, roughly 63% are doing so primarily as a form of risk management. Given their long time horizons and institutional goals of societal betterment, endowments and foundations are adopting ESG policies at a rapid rate. In fact, CalSTRS and CalPERS, pension funds for public sector workers in California, are now required by state law to divest holdings in companies which derive more than half of total revenue from mining thermal coal.
High-net-worth and retail ESG demand tends to reflect consumption choices. Millennials have taken a keen interest in the social impact of investments, despite beginning adult life with a financially tougher hand than previous generations. A Morgan Stanley survey found that, compared with 58% of the overall population, 75% of millennials believe that their investments could influence climate change, and millennials are twice as likely as the average investor to check product packaging or invest in companies that espouse social or environmental objectives. This type of ESG investing is typically exclusionary and highly personal but may come at the expense of performance. Growing demand is attracting the attention of investment managers, thus resulting in the proliferation of ESG products regardless of investor naiveté and ignorance of potential investment consequences. In many cases, the threshold for investor adoption is not that ESG strategies outperform non-ESG strategies; when presented with two similarly performing portfolios, one with an ESG label and the other without, investors will likely opt for the ESG lineup. For certain segments of the population, typically those engaged in values-based investing, this similar performance “burden of proof” is lower or nonexistent, with investors willing to sacrifice returns or significantly increase tracking error in order to construct a portfolio that aligns with their principles.
Fiduciary duty and the investment consequences of ESG integration
Is the use of ESG-tailored products offered by the investment industry consistent with a fiduciary duty to protect and grow capital in a prudent fashion? In an interpretive bulletin (IB) issued in 1994, the U.S. Department of Labor (DOL) permitted economically targeted investments only to the extent that such investments presented a similar risk and return profile to those of non-ESG focused investments; this became known as the “all things being equal” test. Then, reversing course in 2008, the DOL raised the hurdle for incorporating ESG factors, stating that their use as inputs into investment decision-making processes should be rare. Acknowledging its flaws and again changing position, the DOL clarified in IB 2015-1 that Employee Retirement Income Security Act (ERISA) money could once again take ESG factors into consideration, reinstating 1994 guidance and the “collateral goals as tie-breakers” maxim. This action acknowledged for the first time that, in some circumstances, utilizing ESG criteria may provide more than just collateral benefits to beneficiaries. The DOL claimed that not only had the 2008 guidance “unduly discouraged fiduciaries from considering ETIs (economically targeted investments) and ESG factors,” but also acknowledged that such factors may be included in the analysis of the economic merits of competing investment choices. The DOL went a step further in early 2016 when it stated that ESG factors may prove to be “intrinsic to the market value of an investment” while simultaneously citing growing institutional adoption.
The Department of Labor’s ERISA guidance has some inferential value in determining fiduciary standards of care in non-ERISA money. Looking beyond the DOL to other domestic regulatory bodies, the Internal Revenue Service (IRS) permits foundation managers to consider the relationship between an investment and the foundation’s charitable purpose, thereby providing increased flexibility for foundations to pursue ESG-driven investments without violating the fiduciary standard of care. Internationally, trends in uniform standards adoption and signatory body membership suggest growing ESG alignment with fiduciary duty. These standards, while young, are quickly gaining traction; the United Nations-supported Principles for Responsible Investment (PRI) and Ceres Investor Network on Climate Risk and Sustainability provide guidelines that signatories agree to uphold, develop, and, in many cases, promote. Figure 6 shows the rapid rise of PRI signatories, totaling 1,885.
PRI signatories include asset owners (e.g., pension funds, foundations, and endowments), investment managers (e.g., BlackRock, Vanguard, etc.), and certain service providers to both. Should Balentine arrive at the conclusion that our fund managers and third-party providers insufficiently drive ESG research and dissemination, we may explore membership in the “service provider” category so that we might gain access to a valuable network that is otherwise inaccessible.
Does the performance data merit the integration of ESG factors by so many parties? The investment consequences of ESG integration can be analyzed on two axes: returns and risk management. To assess such investment consequences, it is necessary to distinguish among the various methods used to invest along ESG guidelines.
Socially responsible investing occurs along a continuum that can be reduced to roughly four degrees of implementation (Figure 7).
Negative screening, or ethically motivated divestment, is the oldest and simplest form of ESG investing. It is exclusionary in nature and tends to hamper portfolio performance since the investment universe is smaller while simultaneously creating excessive tracking error to the investor’s benchmark. Exclusionary screens impose upon investors a constrained portfolio, one that is theoretically suboptimal and more idiosyncratically risky than an unconstrained offering. Consequently, lingering thoughts that ESG investing involves only ethical divestment may delay its broader adoption.
ESG tilts, or “best-in-class” incorporation, do not necessarily require the omission of securities; they may instead involve the reweighting of those securities to favor those with higher ESG composite scores. The investor may place constraints on sector deviation or factor deviation to reduce portfolio tracking error to the benchmark, and will generally extend a level of tolerance to otherwise ESG-poor companies to hold deviations from index characteristics to a minimum. Best-in-class integration may also screen out those ESG factors that remain intolerable; it is not mutually exclusive with the more restrictive negative screening. Closely related but more in-depth (and costly) “bottom-up” ESG integration tends to take a deeper look at any number of ESG factors (typically at the security level), and how those factors may or may not affect the profitability of an organization. Both methods are predicated on one of two (or both) premises:
- ESG integration can improve portfolio performance on an absolute basis.
- ESG integration can improve portfolio performance on a risk-adjusted basis.
Empirically, the investment merits of this portion of the implementation spectrum may be deemed the “muddy middle,” as the data is inconclusive. A 2012 survey of relevant ESG performance studies conducted by RBC Global Asset Management found minimal, if any, performance drag between ESG indices and comparable non-ESG indices. In fact, ESG indices often slightly outperformed non-ESG indices, though this can largely be attributed to the known ESG large-cap growth bias and the general outperformance of large-cap growth over large-cap value stocks since the early 1990s (when the first SRI indices were created). As reporting requirements improve, there will likely be greater exploration of the relationship between individual ESG factors and financial outperformance.
A growing body of evidence espouses ESG integration as a means to effectively mitigate transition risks (i.e., those risks not yet priced by the market, but whose incorporation would likely lead to the repricing of a swath of assets). This idea is salient to exceptionally large investors who effectively own the market and, by their very nature, cannot diversify away systemic risk. Some prominent financial academics, including Robert Litterman, co-developer of the Black-Litterman method for portfolio allocation, are particularly concerned with climate risk. Responding to hastening environmental change, governments may seek to limit carbon dioxide and sulfur dioxide output, which could lead to a sharp and sudden repricing of assets; market benchmarks such as the S&P 500 are typically overweight oil and gas markets relative to those companies’ share of U.S. GDP.
Furthering the case for ESG as a risk management tool, those investors already using ESG criteria to manage risk have likely sidestepped losses related to regulation that targets negative environmental externalities or issues arising from poor governance. For example, MSCI ESG Research downgraded Equifax to its lowest possible rating, “CCC,” in the fall of 2016, citing poor data security measures. In September 2017, Equifax confirmed a massive cybersecurity breach that compromised the personal data of up to 143 million customers. Equifax stock tumbled nearly -26% by month-end.
On the far-right end of the implementation spectrum, impact investing takes a proactive stance toward ESG investing, seeking to effect positive change while generating similar or above-average returns relative to non-impact investments. Impact investing is most often implemented through private equity, real asset, or private debt asset classes and typically affords the possibility of active investor-management engagement. Within public markets, impact investing is akin to thematic investing.
Balentine: facilitating ESG investing at the ends of the implementation spectrum
There is a fallacy that divestment and restricting the source of firm capital is the most effective way to bring about corporate change. Divestment seems to be a mostly theoretical proposition: increase firms’ cost of capital and they should engage in fewer ESG-unfriendly projects. This, of course, assumes no other opportunistic, unscrupulous investor is willing to step in and receive the “sin stock” premium and that funding for the firm will become increasingly difficult to source. Furthermore, as Vanguard Chairman Bill McNabb points out, persistent share price declines could lead to increased privatization of ESG-hampered firms, paradoxically leading to less disclosure and prolonging harmful activity. Making matters worse, conscious consumerism and selectively choosing which products to buy at the retail level are ineffective. The most likely avenue for effecting change has belonged (and will likely continue to belong) to the regulator. If the goal of the investor is simply to avoid benefitting from a “perverse” revenue source rather than truly bringing about change, most asset managers, including Balentine, can and often do provide a highly personalized, values-based option that satisfies this need, typically in the form of a separately managed account.
The empirically ambiguous middle ground of the implementation spectrum suggests that some advantage for early adopters of ESG best-in-class or bottom-up integration may exist. However, the data still suffers from insufficient CSR reporting requirements and a lack of standardization of ESG metrics, many of which are qualitative. According to PwC, 92% of investors say companies are not disclosing ESG data in a fashion that promotes inter-company comparability, hindering investor ability to assess the efficacy of explicit ESG factor integration as a predictor of future portfolio outperformance. Furthermore, historical data may be ineffectual in understanding where a company’s approach to corporate social responsibility is heading. While there is prudence in large institutions acting as universal owners that use ESG criteria to assess market risk, there remains a great degree of uncertainty surrounding the timing of major “transition risks” such as climate change. The potency of ESG as a risk management tool may very well depend on the extent to which ESG issues catch the attention of policymakers.
As an area of ongoing research, Balentine plans to explore the muddy middle of the implementation spectrum while monitoring the evolution of ESG investing as consensus builds around where and how to properly integrate environmental, social, and governance concerns into the investment process. Our efforts will likely invoke the aforementioned “all things being equal” test: if we can construct an ESG- friendly fund lineup using a best-in-class approach without sacrificing liquidity and while satisfying fee and tracking-error constraints, we will. However, such a portfolio will not become the default option for clients until the sources of ESG excess return have been rigorously tested and verified and have proven themselves to be durable in all market environments.
More immediately, for those clients dissatisfied with separately managed accounts that utilize more restrictive ESG screens and who may be seeking to proactively effect change, we advocate impact investing within private markets. This allows for some level of active engagement without sacrificing returns. Options such as green energy and affordable housing real estate funds are readily available. Investing in private markets involves unique risks, including long lock-up periods, and requires a highly disciplined approach to improve the odds of investor success. The manager of the investment must offer active management beyond the point of commitment in exchange for the high fees charged and should not rely on excessive use of leverage to drive returns. Any impact investment we make in private markets will be subjected to such criteria.
It is estimated that meeting UN Sustainable Development Goals will require nearly $7 trillion in investment through 2030. Our clients could help provide this capital and play a powerful role in bringing about meaningful, positive societal change while remaining firmly within the bounds of their financial goals.