What is ESG Investing ? Explained in Detail.

  • 4 May 2020 | 456 Views | By
Environmental, Social, and Governance

A successful investor is one who knows all tricks of the trade. He not only knows the game but also knows how to play it better than others. As an investor, do you know about ESG Investing? If not, you are missing important investing options.

What is ESG Investing?

ESG stands for Environmental, Social, and Governance. ESG investing is also known as “sustainable investing.” The Financial Times Lexicon defines ESG as “a generic term used in capital markets and used by investors to evaluate corporate behavior and to determine the future financial performance of companies.” 

It is an investment option that seeks positive returns and long term impact on the environment, society, and the performance of the business. There are several different categories of sustainable investing like impact investing, socially responsible investing (SRI), ESG, and value-based investing.

Check out this interesting read on scientific investing.

Why is ESG investing important ?

Using it, investors determine the future financial performance of companies and evaluate corporations. It is a subset of non-financial performance indicators which include ethical, sustainable, and corporate governance issues such as managing a company’s carbon footprint and ensuring there are systems in place to ensure accountability. They are factors in investment considerations, used in risk assessment strategies incorporated into both risk management processes and investment decisions.

What are ESG principles?

ESG investing looks at “extra-financial” factors or variables. Intelligent and responsible investors evaluate companies using ESG criteria as a framework to look for investment options or to assess risk in investment decision making.

Environmental factors determine a company’s stewardship of the environment and focus on pollutions and waste, greenhouse gas emissions, resource depletion, deforestation, and climate change. Social factors take into consideration how a company treats people and focuses on employee relations and diversity, local communities, working conditions, conflict, health, and safety. Governance factors take a look at corporate policies and how a company is governed by the management. They focus on executive remuneration, tax strategy, corruption and bribery, donations and political lobbying, and board diversity and structure.

ESG Investing
How are you saving Mother Nature?
Image by annca from Pixabay

ESG investing can take various forms. The S&P Dow Jones Index splits sustainability into two categories:

  1. Green or low carbon, and
  2. ESG.

The ESG framework of investing tends to capture more factors, while green is more focused. Environmental factors include water management, waste management, environmental impact, environmental resource use, environmental disclosure, and reduction of pollution and emissions. Social factors include stakeholder analysis, diversity community relationships, workplace mentality, human rights, corporate citizenship, and philanthropy. Governance factors include stakeholder impact, board structure, management compensation, stakeholder rights, and the relationship between management and stakeholders.

How appealing is ESG investing?

Most investors are not only interested in the quarterly results of the companies but also interested in the impact of their investments. They are also interested to know the role their assets can have in promoting global issues like global warming. ESG investing is particularly popular among millennials. As per a study, when the company has a reputation for being socially or environmentally responsible, then millennials are more likely to trust a company or purchase a company’s products. On the other hand, a big percentage of those millennials surveyed turn down a product or service from a company perceived to be socially or environmentally irresponsible.

What is the Difference between SRI & ESG?

At this point, it is important to know the difference between SRI and ESG. Socially Responsible Investing (SRI) was started in the 1970s as investors mostly used negative screening methods to exclude investments in tobacco, guns, gambling, adult entertainment, and other such industries. It started a trend, where investing in such stocks was considered bad since these are socially irresponsible businesses. The idea was that the investment should go to companies that are morally “good”. ESG investing is sometimes considered synonymous with SRI, is its own class of investing.

How do ESG money managers work?

A successful ESG manager follows the below strategy:

  • First, he, identifies a set of compelling investments based on his traditional selection criteria.
  • He then applies the ESG lens to this set of viable investments.
  • Finally, he selects those investments that are anticipated to generate a scalable, profitable impact.

The reason why returns and impact need not be mutually exclusive is because the ESG lens is only applied to profitable investments that have been identified pre-lens.

ESG Investing Trends

Top trends that will unfold in the coming years in ESG investing are:

Climate Change Innovators

 A few years back a lot of startups have come up in this space but at present, a lot of established big players are putting in their time and money assembling an arsenal of climate solutions. In 2020, investors will try and spot the companies which will lead us towards a carbon-free economy.

New terms for capital

Investors now are keen to channel their money toward green energy projects. ESG has mostly been tossed to the corporate social responsibility office or used to prettify annual reports for the average, middle-of-the-road company.

The New Human Capital Paradox

There is pressure on the companies to transform their workforces as competitors go digital, automated, and everything in between. Not only workers are in need of disparate new skills but also HR and management. In the coming years, many more companies will have to become human capital multi-taskers, laying off some workers on the one hand while on the other simultaneously recruiting scarce new kinds of talent that may seem alien to the management of the company. Like a high wire juggling act, any lapse could prove disastrous.

ESG Funds 

Some years back, the number one question portfolio managers used to get from investors was – aren’t you limiting your options and sacrificing returns by doing ESG? The funds’ results have made sure investors stop putting this question. Nine of the biggest ESG mutual funds in the United State outperformed the Standard & Poor’s 500 Index last year. 7 of them beat their market benchmarks over the past five years.                               

Investing in the ESG funds graph has shown it is a money-making opportunity that is gaining popularity with every passing year.

Where do most ESG funds go? What companies are ESG?

The top-performing funds bet heavily on finance and technology services companies, which have historically been low-emission sectors. Tech companies, including Apple Inc, Microsoft Corp., and Alphabet Inc., were staples of many of the top-performing ESG funds, as were credit-card companies Mastercard and Visa Inc. Health-care companies Danaher Corp. and Thermo Fisher Scientific Inc. were other standouts, even though healthcare was one of the worst-performing sectors in the Russell 1000 Growth Index during much of last year.

Still a long way to go

Sustainable mutual and exchange-traded funds held $137.3 billion in total assets at the end of 2019 — or less than 1% of the $20.7 trillion held in the universe of exchange-traded and mutual funds in the U.S.

What are the best ESG funds?

UK

The best fund in the UK is the Pictet Global Environmental Opportunities fund which has delivered a return of 31.8% year to date(2019) and covers sectors like energy efficiency and pollution control. Environmental monitoring equipment has been a strong theme for this fund. Holdings tapping into this trend include Agilent, Thermo Fisher, and Ecolab. Of course, one downside of the growing attention these companies are getting is that their share prices are now starting to look expensive.

US/Global

Morgan Stanley’s Global Opportunity Fund(managed by Kristian Heugh) focuses on finding companies that use strong management to minimize negative impacts on the society and environment over time. It also incorporates sustainability analysis into every portfolio position they take. Its benchmark index is MSCI All Country World and it has an annual return of 17.60% over a period of 5 years.

India

ESG is on the lips of most of the advisors and fund managers. Quantum Mutual Fund was the first one to launch an ESG scheme, followed by SBI Mutual Fund. The issue that mutual fund advisors have with ESG funds is that there are not many companies in India that fall in the ambit of the ESG index. The ESG index has been in India for some time now but the issue is companies are mostly large-cap in the index.

ESG in time of Coronavirus

The world economy has seen a sharp downfall and most of the world market is down 20-30% from the peak. ESG funds are exhibiting some resilience so far in the downturn. But experts cautioned against reading too deeply into their short-term relative better performance.

Find out how coronavirus is impacting the global economy.

The world economy going south is also forcing some ESG investors to reconsider their corporate engagement strategies as many companies struggle just to stay afloat to refit their factories to produce needed medical supplies. Fredrik Henzler, a partner at Partners Group Holding AG, said the Swiss private equity firm is postponing some 2020 ESG initiatives for the hardest-hit companies in its portfolio.

Overall, it is an interesting way of investing where your investments do not give good returns but also a satisfaction that your investments are with companies which are environmentally friendly and socially responsible.

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