There is probably no better time to talk about environmental, social, and governance (ESG) investing than now. The coronavirus pandemic has completely changed people’s daily lives and disrupted the financial market. Yet amid the stock market turmoil, shares of companies focused on climate change or ESG issues outperformed as the virus spreads. According to a report by HSBC Research , the climate-focused stocks in Asia-Pacific outperformed that region’s index by 13.6 per cent since 10 December and 5.6 per cent since 24 February.
ESG investing — or strategies that take a company’s environmental, social and governance factors into consideration — grew to more than $30 trillion in 2018, according to Global Sustainable Investment Alliance , and that number is set to grow further. As ESG investing transforms itself from niche to mainstream, Asian retail investors might find themselves at a disadvantage ignoring this global trend. These investors expect their financial intermediaries and wealth managers to offer them a solid ESG investment opportunity.
So how do retail investors incorporate ESG strategies into a portfolio? And what are the implications for portfolio performance and investment strategy as funds shift away from assets with low ESG scores to assets that score higher? Here we will look at the evolution of ESG investing, what is behind this trend and an example of a strategic portfolio.
The term ESG is not new. It was coined in 2004 by the then UN Secretary-General Kofi Annan who asked CEOs of financial institutions to take part in an initiative to integrate ESG into capital markets. Since then, ESG has evolved and moved from the sidelines to the forefront of decision-making for asset managers and institutional investors. Just in January this year, BlackRock, the world’s largest asset manager, stated in its annual letter to CEOs “We believe that sustainability should be our new standard for investing”. In the letter, BlackRock’s CEO Larry Fink writes that climate risk is investment risk. And he is not alone. The Bank for International Settlements, sometimes referred to as the central bank of central banks, has just published a book titled “Green Swans”. A Green Swan is a disruptive event like the climate crisis that could trigger a systemic financial crisis.
Investors, large or small, that are ignoring ESG-related risk and opportunities, risk being left in stranded assets. A stranded asset is a previously productive but rapidly devaluing asset due to a variety of factors including technological or social change. Fossil fuel resources are often cited as potentially stranded assets as the world makes a concerted effort to move away from fossil fuels. For example, the Royal Bank of Scotland announced that the bank will stop lending and offering underwriting services to major oil and gas producers that do not have credible transition to a low carbon economy and also pledged to fully phase out coal financing by 2030. Investors in such companies might find their investments run dry.
And how can a retail investor make sure her portfolio takes ESG factors into account and profit from the global trend? Luckily, there are plenty of actively managed ESG funds, and many conventional ETFs that have an ESG sibling. For example, the Legg Mason QS Investors Global Equity ESG Model US Strategy on Quantifeed’s digital investing platform includes the iShares ESG MSCI USA ETF. It selects companies with high ESG ratings in each sector to maximize exposure to ESG factors while tracking the conventional MSCI USA index within a narrow band.
This strategy also includes the Legg Mason ClearBridge Large Cap Growth ESG ETF and the Legg Mason Global Infrastructure ETF to produce a diversified and attractive global ESG equity portfolio. While the ETF is sector-diversiﬁed, tobacco and controversial weapons companies and producers of or companies with ties to civilian firearms are not eligible for inclusion. In this case, the ESG ratings are the result of a complex yet transparent MSCI internal data-based process and the evaluation of 37 key issues for each industry. Companies are assigned an aggregated ESG score on a scale of nine levels. There are also a range of other data providers for ESG ratings and analytics on a company level.
The inclusion of ESG factors seems profitable. According to a report by Morgan Stanley’s Institute for Sustainable Investing , 65% of sustainable funds rank in the top half of their respective Morningstar category through November, and 48% of large-cap blend sustainable funds are beating the S&P 500 this year. Similarly, the iShares ESG MSCI USA ETF outperformed the Invesco PureBeta MSCI USA ETF by 1.7% (23.2% vs. 21.5% respectively) over the past 12 months. The outperformance is replicated in other markets; the iShares ESG MSCI EAFE ETF outperformed the iShares MSCI EAFE ETF by 1.9% (9.0% vs. 7.1% respectively) over the same period.
Though ESG investing started with an objective of moral goals, it is now increasingly driving investors’ agenda globally. Having a well-diversified and balanced portfolio with ESG strategies offers investors a choice which is good for the planet and good for performance.