A group of investors convened under the auspices of the United Nations in 2004 to discuss how to further the aims of the UN Global Compact. The group’s subsequent report coined “ESG” as it recommended ways for asset management to include “environmental, social and corporate governance” factors in investment decisions.
The report, titled “Who Cares Wins,” set off two decades of growth in ESG, as most of the world’s notable asset managers incorporated ESG considerations into their investment analysis and many created investment strategies and funds with ESG analysis playing a central role.
The asset management industry’s response also led to confusion around ESG for investors, financial advisors, and regulators. That confusion eventually took the bloom off the ESG rose and led to criticism both within the investment industry and in the political sphere.
One way for investors today to clear up some of the confusion is to distinguish between ESG as part of an investment process and ESG as an investment strategy, or product. As originally conceived, ESG was about process, not product.
ESG as a process
For asset managers, the gist of the 2004 report was for them to consider adding ESG information and analysis to their process. Many have done just that over the last two decades, helping them understand risks and opportunities that may not be apparent through the traditional lens of financial statements, but that are nonetheless financially material.
“The institutions endorsing this report are convinced that in a more globalised, interconnected and competitive world the way that environmental, social and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully,” the 2004 report stated.
The report continued: “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.”
In this context, ESG is simply information. It now takes the form of data and ratings of public companies that help investors understand the ESG challenges that may be relevant to an investment decision. ESG information is thus an input to the investment process. ESG analysis is the interpretation of that information as part of the investment decision-making process.
Adding ESG information to the investment process provides a more complete view of a company. This is especially relevant today when the typical large corporation has more intangible than tangible assets on its balance sheet, and issues ranging from climate change and natural-resource limits to competition for talent and perceptions of a firm’s broader impact on the world can have material ramifications.
There is no single correct way to use ESG information, and so we see considerable variation across asset managers in how they integrate ESG into their processes. Virtually all focus on what they consider to be financially material ESG issues, which can vary by industry and company.
The overall influence of ESG on an investment process varies across asset managers. For some, ESG may play a central role in the investment analysis; for others, ESG may only come into play on occasion.
[Read more: ESG-conscious investors are more insulated from the stock market’s wild swings]
ESG analysis also helps guide asset managers in their direct engagements with companies they invest in and in their proxy voting. Some take a traditional approach, focusing on pressuring companies to mitigate their ESG-related risks or to take advantage of ESG-related opportunities.
Others take a broader “systems-level” approach, engaging companies today about how they can help mitigate global systemic risks like climate change and economic inequality that could have negative outcomes for investors in the future. By doing this now, asset managers can help ensure durable risk-adjusted returns for investors over the long term.
In sum, ESG as a process is about using ESG information and analysis to better understand investment risks and opportunities in a complex world both now and over the long term. It is not a matter of politics or values, it is about asset managers trying to do their job better.
ESG as a product
Given that there is no single way to incorporate ESG into an investment process, it follows that ESG products, or funds, are not all alike. Keep in mind that many mutual funds, perhaps most, may consider ESG information to some degree in their investment analysis.
By contrast, funds that highlight ESG as central to their strategy and use ESG or related terms in their names have gathered trillions in assets globally over the past two decades. Such funds generally have the twin objectives of generating competitive returns and taking into consideration their broader impact on ESG issues.
Some of these funds seek to minimize negative impacts, while others seek to create positive impacts on people and the planet. Whereas the many traditional funds that now incorporate some consideration of ESG generally focus on risk mitigation, those that emphasize ESG seek more actively to avoid ESG “laggards” and emphasize ESG “leaders” in their portfolios.
Some ESG funds leave it at that. But others incorporate values-based criteria that limit their exposure to products or industries that have negative impacts on the world. Examples include tobacco, guns, and coal, among others. But there is no standard list of exclusions. Some ESG-focused funds are fossil-fuel free, but not all.
Likewise, some ESG funds emphasize sustainability themes and many of them now report to their investors on the positive impacts of their holdings. This includes the asset managers’ direct engagement with companies around ESG issues, which may include sponsoring shareholder resolutions and proxy voting that reflects ESG concerns.
Keep in mind, too, that ESG funds vary in their use of traditional investment approaches. Some are growth-oriented, while others (not as many) lean toward value. They have different valuation disciplines and sell criteria. Some are actively managed and some are passively managed funds that track ESG indexes. Not surprisingly, there is also considerable variation in how ESG indexes are constructed.
That leaves us with three takeaways. First, to clarify your understanding of ESG, it’s helpful to distinguish between ESG as a process and ESG as a product.
Second, virtually all asset managers use ESG as a process to help them fulfill their fiduciary responsibilities.
And finally, although ESG products, or funds, are not all alike in terms of their sustainability or financial approaches, they share the common objectives of competitive returns while considering the broader impact on people and planet.
Read more: Green Century president talks ‘right to repair,’ NextGen investors, election stakes and more
