As Another Decade Opens, Appetite for ESG Remains Strong

For all the headlines dedicated to the topic of environmental, social and governance (ESG) investing, there remains considerable uncertainty over what exactly it means, says George Michael Gerstein, co-chair of the fiduciary governance group at Stradley Ronon.

In a recent blog post and in previous conversations with PLANSPONSOR, Gerstein has called this fact unfortunate, “not least because it is hard to comply with fiduciary duties if the conduct at issue is a moving target.”

“The fact is, with proper structuring, a fiduciary to an ERISA [Employee Retirement Income Security Act] plan, or a governmental plan, for that matter, can favorably respond to requests for ESG issues to be part of the investment mandate without losing much sleep over fiduciary duty risk,” Gerstein says.

According to Gerstein, slow but steady progress is being made by ESG investing advocates, who make the case that ESG risks are already material to investing decisions. At this stage, he explains, there are four primary techniques for addressing ESG risk.

“First, one can screen out from investment consideration those portfolio companies that fail to satisfy one more ESG risk-related criteria, known as negative screening. For convenience, divestment, can be included in this category because it is effectively screening out existing holdings,” Gerstein says.

The second technique is to limit the investible universe to those “best-in-class” portfolio companies that satisfy ESG risk-related criteria. Gerstein explains this technique is known as “positive screening.”

The third technique is treating an ESG risk like any other material risk to investment performance, “no more and no less.” This is known as integration, Gerstein says. The fourth technique is to address ESG risk through proxy voting and other forms of shareholder engagement.

“At this stage, we now recognize that ESG is an umbrella term that encompasses myriad environmental, social and governance risks,” Gerstein adds. “We appreciate that ESG can be boiled down to discrete risk areas, such as cybersecurity or board diversity, and that [investors and their advisers] can focus on only one of these risks as part of their mandate.”

Gerstein says it is worth noting at this point that the DOL’s most recent guidance on ESG, Field Assistance Bulletin 2018-01, expressly reaffirmed the notion that ESG issues can present material risks (and opportunities) for retirement plans, and, consequently, could be treated the same way as any other factors a fiduciary would consider as part of a prudent process.

“The DOL cautioned fiduciaries against making too many assumptions and against not relying on the evolving data linking one or more ESG issues with investment performance,” Gerstein notes. “This makes sense and should not present too much of an operational nuisance, considering that more fine-tuned data is available reportedly showing one or more ESG issues as being material to performance.”

Positive Compensation?

Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management (NTAM), also spoke extensively this year with PLANSPONSOR about the evolving ESG topic.

According to Hunstad, outside of the U.S., almost all the institutional business NTAM engages in already involves the ESG lens to some capacity. He says institutions in Europe, Asia and Latin America have come to accept that ESG is a material issue when it comes to long-term asset performance—both as a source of risk and a potential source of return.

“Is ESG a factor, say, in the way of stock value or momentum?” Hunstad asks. “There are two ways to look at this question.”

The first is to say that ESG is an independent source of risk that must be addressed.

“In my opinion, you simply cannot argue against this,” Hunstad says. “Consider what happened with Volkswagen’s stock when the emissions cheating scandal came out. That is bad governance, and it is absolutely a source of material risk today that will impact your portfolio, if ignored. So if you can measure governance, and you can control the risk around governance, that’s enough for me to say that ESG is a factor that should be addressed during portfolio construction.”

The risk issue may be settled, Hunstad says, but it is equally important to ask the next question, i.e., whether ESG is a positively compensated factor? In other words, will an investor see excess returns for going overweight in ESG-conscious stocks?

“We have to be careful in this analysis,” Hunstad suggests. “I like to say that the best case for higher performance of ESG stocks is over the long-term.”

The case goes as follows. For those companies that have taken concrete steps to comply with environmental regulations or have strong cultures of governance and are globally and sustainably minded, they have already borne the cost of embracing this way of doing business. Crucially, the fact already shines through in their financial statements. On the other hand, those companies that have done nothing to consider ESG issues, their financials do not reflect these unknown future costs.

“The important point is to say that these companies will eventually have to bear these costs in the future, which will inevitably be a headwind for their stock price and financial performance,” Hunstad says. “Additionally, we have found that ESG absolutely can be a compensated factor when you weed out low-quality companies from your portfolio. There are stocks out there that rank highly on the ESG perspective that you don’t want to own from a financial perspective. If you get rid of those, the stocks that are left over, the high-qualit,y high-ESG-rated stocks, tend to do very well.”

Which is most important, ‘E,’ ‘S,’ or ‘G’?

Although much of the global attention within the ESG sector of investing has been placed on the environmental component, the ESG Investor Sentiment Study from Allianz Life Insurance Company of North America found that in the U.S., social and governance issues are equally important as or more important than environmental record when consumers decide whether or not to invest in or do business with a company. Furthermore, the study found that a company’s ESG profile plays a significant role in its overall reputation as a majority of consumers believe companies focused on ESG issues have better long-term prospects.

When asked about the importance of a variety of ESG topics in making a decision to invest in a company, 73% of American consumers noted environmental concerns like natural resource conservation or a company’s carbon footprint/impact on climate change. However, the same percentage emphasized social issues such as working conditions of employees or racial/gender equality, and 69% highlighted governance topics like transparency of business practices and finances, or level of executive compensation, as being significant in their decision making.

Related research from Morningstar finds most investors, across ages and genders, have clear preferences for environmental, social and governance investment products. Using a research method the firm calls “the My Sustainability Profile,” which measured the sustainability preferences of some 1,000 investors, Morningstar found that, overall, 72% of the United States population expressed at least a moderate interest in sustainable investing.

The research found that while women have a slightly stronger preference for sustainable investing than men, the difference between the weighted averages was small. In addition, this small difference disappeared after controlling for income, age, political ideology, religiosity, risk tolerance, financial literacy, and other sociodemographic variables.

The results also bust the myth that different generations have substantially different preferences for sustainable investing. The average preference score for Millennials and Generation X were statistically equivalent, and while Millennials, on average, showed a slightly stronger preference for sustainable investing when compared to Baby Boomers, the difference didn’t exist after including sociodemographic variables.