1. About ESG
What is ESG?
Like you, many high-net-worth investors are increasingly curious about how they can build a more sustainable portfolio. Against the backdrop of new global sustainability challenges; the rise in environmental, social and governance (ESG) data; and the pending $30 trillion wealth transfer to millennials over the next few decades,(1) we have seen a rapid rise in ESG investing. In fact, an estimated 1 in 4 dollars of U.S. assets under professional management are using socially responsible investing strategies.(2)
This is a quick primer on ESG—what it is, how it has evolved, and how you can partake. The biggest takeaway is that, regardless of the sometimes confusing industry jargon, the essence of ESG is aligning your portfolio with your values by incorporating environmental, social, and governance factors into your investment process.
MSCI, a leading ESG data provider, defines ESG as “the consideration of environmental, social, and governance factors alongside financial factors in the investment decision-making process.” In short, it’s possible to focus on financial goals while also directing capital toward companies that are advancing the issues you care about most. More specifically:
The Environmental lens looks at how companies interact with and impact our natural world by engaging in activities such as deforestation.
The Social lens looks at how companies affect the preservation of human rights, dignity and representation through practices such as fair working conditions.
The Governance lens looks at how companies are governed and examines factors such as board diversity and tax transparency.
The term “ESG” is often used synonymously with sustainable investing, socially responsible investing, impact investing, or screening. These terms fall under the ESG umbrella, and can refer to different approaches to ESG investing based on the objectives and motivations of investors like you.
We've recently seen many investors refer to ESG or sustainable investing as "full information investing." Given its incorporation of data beyond financial factors, ESG can be used to identify companies with stronger governance practices, or those whose business model is prone to disruption by rapidly evolving regulatory, environmental, demographic or technological trends.(3) It makes sense, then, that many investors are viewing ESG factors as a form of risk management and a barometer for companies’ longer-term financial performance.
How did ESG originate?
The practice of ESG investing has been around since the 1960s, when socially minded investors began to consider in earnest how their financial holdings reflected their own distinct values. This led to the exclusion of so-called “sin stocks”— for example, companies involved in the production of tobacco or firearms— from their portfolios.(3) Through the years, the field rapidly evolved, with the term “ESG investing” first emerging in a 2005 study, entitled “Who Cares Wins,” by the International Finance Corporation, a sister organization of the World Bank and member of the World Bank Group. The report made the case that embedding environmental, social, and governance factors in capital markets yields positive results for society.
Since then, ESG has seen rapid growth. The U.S. Forum for Sustainable and Responsible Investing (US SIF) first began measuring the size of the U.S. sustainable and responsible investment universe in 1995. Since then, assets invested in these strategies have expanded from $639 billion to $12 trillion—a compound annual growth rate of 13.6 percent.(2)
Why is ESG growing?
Four key drivers have accelerated ESG growth:
1. New global sustainability challenges:
Variables such as climate change, information technology, globalized supply chains and various social movements are introducing new risk factors for investors.
2. Increased demand from millennials:
According to the 2019 Morgan Stanley Sustainable Signals report, 95% of millennials want to invest sustainably.(4) It’s estimated that, over the coming two to three decades, this generation could place between $15 trillion and $20 trillion into U.S.-domiciled ESG investments, approximately doubling the size of the U.S. equity market.(3)
3. Improved data & analytics:
Between 2011 and 2018, the share of companies in the S&P 500 that reported on sustainability went from 20% to 86%.(5) This increasing data availability has brought with it an explosion of ESG ratings—as of 2018, an estimated 600 sets of ESG ratings and rankings existed.(6) With data increasing in quantity and quality, we are capable of more systematic and quantitative approaches to key ESG issues.
4. Meaningful adoption by leading institutional investors:
Since its founding in 2006, the United Nations Principles for Responsible Investing (PRI) has attracted support from more than 1,800 signatories committing to six voluntary principles, the first of which is the incorporation of ESG issues into investment analysis and decision-making.(3)
2. ESG and my portfolio
Does ESG sacrifice returns?
Consideration of ESG factors can provide investment advisors with additional context on the risks of investing in a company, arguably without compromising returns. In fact, a growing body of research suggests that companies that prioritize responsible and equitable business practices—including environmental safety, workplace diversity and strong corporate governance—may, in the medium and long term, outperform those that do not.(3) (7) In a recent study conducted by MSCI, companies with higher ESG ratings were associated with higher profitability, lower tail risk, and lower systematic risk.(3)
At Ethic, we manage passive equity portfolios. This means that, instead of shifting your current allocation, you are simply transitioning your passive equity sleeve to a cleaner alternative, which seeks to track your chosen benchmark within the bounds of your current financial plan. We work with you to establish sustainability inputs and a tracking error budget that you are comfortable with.
How can I participate in ESG?
Despite ESG meaning different things to different investors, there are three common investor objectives that fall under the ESG umbrella: Values, Risk and Impact.(3)
"My investments should reflect my values"
Investors seeking to align their investments with their values and beliefs.
"I believe that integrating ESG may improve my investment results"
Investors seeking to incorporate ESG data to control risks and seize opportunities in hopes of improving long-term risk-adjusted returns.
"I want my investments to make a difference in the world"
Investors seeking to support measurable social or environmental benefits alongside a financial return.
In order to achieve your specific goal or objective you can pursue different approaches such as ESG integration, negative screening, or thematic investing, among others. You can apply these to a portion of your portfolio through specific asset classes like fixed income and equities. For example, you can invest in green bonds or ESG exchange-traded funds (ETFs) and mutual funds. Consult your financial advisor to talk about how to best approach ESG in the context of your overall financial objectives.
3. ESG and Ethic
How does Ethic empower me to participate in ESG?
At Ethic, we help you align a portion of your portfolio—your passive equity sleeve—with your values through a personalized separately managed account (SMA). We incorporate all three ESG investor motivations—values, risk and impacts—into our process by understanding your values, integrating them into your portfolio and measuring your impact through our proprietary impact reporting. We offer a personalized approach to ESG, and provide transparency into how your investments are achieving the impacts you seek.
Here is a quick video on how Ethic can work with you to align your investments with your values.