Exponential growth in recent years has brought ESG investments firmly into the mainstream. By the end of 2018, investments labelled “sustainable” were worth more than USD 30 trillion – the same as the combined GDP of the United States and the eurozone. But can a green label guarantee decent returns?
ESG investments will soon account for nearly half of all assets managed by the industry worldwide. They already accounted for more than 40% of AUM in 2019, having grown by 34% between 2016 and 2018. ESG-only funds saw their assets hit the USD 2 trillion mark by the end of June 2019. The decade ahead could be to ESG what the previous decade was to ETFs: a huge window of opportunity.
Right now, these investment solutions have excellent momentum, driven both by politically supported enthusiasm among the general public and by a recent surge in demand among institutional investors, who are increasingly sensitive to social values. ESG is proving popular with small-time savers and multi-billion-euro pension funds alike.
ESG-only funds saw their assets hit the USD 2 trillion mark by the end of June 2019
ESG is no longer a compromise strategy
Clearly, the current enthusiasm for ESG investments is not simply because they are fashionable. Widespread demand for more responsible practices cannot explain everything. Investors might be choosing to invest in companies that put ESG criteria at the heart of their growth strategies, but they so do above all because they expect to be rewarded with returns. These companies must demonstrate that they can transform their various ESG commitments into ways of creating value.
Today, it is broadly acknowledged that ESG aspirations and financial performance can go hand in hand, despite having been somewhat divergent in the past. Investors are no longer having to compromise. These days, incorporating ESG factors into an investment strategy can deliver significant profits. As a general rule, applying ESG filters contributes to optimal portfolio management, whether this be active, passive or smart beta, with no impact on risk-adjusted returns.
There are several reasons for this. A decade ago, companies were not as well versed in ESG policies. This meant that social responsibility was in no way one of their priorities. In 2011, according to a study by KPMG, fewer than 20% of companies listed on the S&P 500 published information about their ESG strategy. Investors of all descriptions still saw the ESG universe in the same way they had looked at the emerging markets at the beginning of the 2000s: vast swathes of unchartered investment territory about which little was known or documented.
The lack of non-financial data available at the time considerably reduced investment opportunities, resulting in a lack of diversification which meant that funds were not as profitable as they could have been.
A proven, profitable investment strategy
Companies are now increasingly vocal about their ESG positioning, and ESG rating agencies are producing vast amounts of data. For listed companies, ESG data have become almost as commonplace as traditional financial data, and this has broadened investors’ horizons. Thousands of studies have presented an overall picture of strong performance in the “all-sustainable” era. A simple look at Morningstar’s ESG indexes will prove the point. Launched in 2016, they use specific analysis conducted by Sustainalytics to group together the best-performing companies with respect to ESG in the different regions. Rather than operating a policy of exclusion, they favour companies known for their excellent ESG practices.
Between December 2009 and the end of 2017, the Morningstar Europe Sustainability Index returned 9.1% per year on average, which is slightly higher than the return of the Morningstar Europe Index. Morningstar believes this slight difference to be significant. Over the course of those nine years, the portfolio of the companies with the best ESG profiles returned 2.3 times the performance of the portfolio featuring the companies with the worst ESG profiles.
Having taken several years to gain traction, ESG filters are now considered to be sources of alpha with an excellent long-term outlook.
A winning risk/reward profile
In the 1970s, the economist Milton Friedman was perhaps a little too quick to suggest that corporate social responsibility was first and foremost about generating profit. Since then, his theories appear to have been blown out of the water. Michael Barnett, from the University of Oxford, and Robert Salomon, from New York University, studied the performance of 1,214 companies listed on the S&P 500 and the Russell 3000 between 1998 and 2006. They found that the companies most committed to sustainable development were the most profitable.
When their findings were published, funds invested in these companies received a substantial boost. By applying an ESG-led approach, asset managers can identify new value-creating opportunities while ensuring better control of risk.
With statistics like these, it is clear that growth in ESG investments will continue to accelerate for a good while yet.