“How to be future ready:
ESG’s rapid growth:
$22.8 trillion (2016)
$30.6 trillion (2018)
Over $35 trillion (2020)
ESG assets are on track to exceed $50 trillion by 2025, more than a third of the projected $140.5 trillion in total global assets under management.
$1 trillion ESG ETF market and a $11 trillion ESG debt market expected by 2025.
ESG ETF and ESG debt are leading the growth among ESG investing strategies.
But as with all good ideas, there are many things to watch for, and plenty to learn. It’s not as easy as before, where for example, an investor could scan for a dividend history payout, compare it to a company’s or sector’s growth prospects and divine a reasonable projection of how their investments would perform. ESG investing is a little more complicated, with a number of factors to take into account. In this article, we’ll look at some of them.
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A few concerns to take note of.
It’s good to remember that there will always be leaders and laggards. Somewhere in between usually lies some of the best hidden potential for growth.
Will supply meet demand?
Today, more and more investors are looking to invest in companies that can be part of building a better future. While some describe it as a ‘trend’, ESG investing has shown that it is here to stay and is growing into a dominant force. Why would we say so? In recent years, leading institutional investors have been steadily rebalancing their funds toward investments that have strong ESG qualities. We are now often seeing large reported movements such as these:
”UK pension scheme pledges £5.5bn for green strategies” - Financial Times, July 20, 2020 and ”Heavyweight Nordic investment trio makes €4bn green infrastructure pledge” Responsible Investor, Nov. 10, 2020.
More investors are also seeking green bonds, as shown by Germany’s first-ever sovereign green bond in 2020 that raised EUR6.5 billion and was five times oversubscribed. Or we can look at the movements from the UN-convened Net-Zero Asset Owner Alliance, who represent over USD5 trillion in assets. It is a remarkable sum from an international group of 66 institutional investors who are committed to transition their portfolios to a net-zero greenhouse gas emissions by 2050.
”Germany Seizes on Demand for Green Debt With $7.7 Billion Debut.” Bloomberg. Sept. 20, 2020.
”Institutional investors transitioning their portfolios to net zero GHG emissions by 2050.” UNEP’s Finance Initiative. Nov. 19, 2020
Accordingly, the supply of such investment opportunities should grow over time given the support of stronger policy measures and development of more robust carbon markets. We can even see that here in Malaysia, where Budget 2022 and the recent 12th Malaysia Plan have made the green economy a major focus point. This is nothing spectacular, but it is in line with what many countries worldwide are shifting towards.
In the meantime, given the growing momentum, investors will likely be aggressively seeking green assets and potential breakthrough technologies that are on the horizon.
Everything is connected,
without the E, there is no S or G.
All over the world, there is pressure on corporations to play their part in building a better future when it comes to caring for their employees, the communities where they work and stronger governance from their boards of directors and regulatory bodies.
Companies are getting better at communicating: but does this mean they're really improving? In our age where social media is more often becoming a primary source of information for many, it is important to dig a little further. Of course, news about environmental concerns would be the first to spread, as the effects of climate change are clearly visible, and many natural disasters can quickly be ascribed to it. So far, it has been easiest to track the environmental portion of ESG investing. What is a little harder to spot are the social and governance aspects. Make no mistake, all three need to be working hand in hand to deliver results.
Besides that many new regulations come into play in recent times. For example, the Task Force on Climate-related Financial Disclosures (TCFD) reporting became mandatory for UN PRI signatories in 2020, and will be required over the next few years in the U.K., New Zealand and possibly the U.S. The European Union’s Sustainable Finance Disclosure Regulation (SFDR), if finalized in its current form, will require investment institutions to report if the companies they invest in operate in or around areas of high biodiversity value. And this is just the tip of the iceberg.
“FAQ on mandatory climate reporting for PRI signatories.” UN PRI.
“U.K. Requires Companies to Report on Climate Change by 2025.” The Wall Street Journal.
“Mandatory climate-related financial disclosures.” New Zealand Ministry of the Environment.
“Biden plan to make companies disclose climate risks key to decarbonization.” S&P Global.
Newer funds may hold more promise.
And this is simply because they’ve had more time to study the movements and progression of ESG investing. Being late to the game is not a negative, instead it allows a fund time to develop its strategy by learning from other’s mistakes. In the early days of ESG investing, it was quite possible to simply avoid the obvious negatives − the energy sector or energy intensive industries for example, or the agriculture sector given its necessary exposure to the usage of and potential damage caused to land, natural resources as well as human rights or labour issues.
Some have even taken to avoiding entire regions that don’t have a long history of considering ESG type factors. Removing these from your portfolio would have helped avoid some of the pressures these sectors have seen over the past couple of years. But simply avoiding issues isn’t the core of what makes ESG investing work.
New analytical tools have helped researchers isolate the contribution of specific ESG factors to explain performance regardless of industry, country, currency and other factors. That is how companies like MSCI, Sustainalytics and Morningstar can provide reliable ESG ratings. They measure industry and company specific ESG issues as well as the ability and effectiveness of management teams in addressing the issues that arise.
These tools also show that ESG factors contributed more to explaining the performance of select MSCI ESG Indexes in 2020 than any other traditional financial factor — including exposure to the energy sector. So there are ways to look into sectors that some may deem to be riskier.
“MSCI ESG Indexes during the coronavirus crisis.” MSCI Blog
“ESG Investing: Practices, Progress and Challenges.” OECD.
What to look for.
It’s good to remember that investing is always a dynamic process, even for long term holders. It’s always better to rely on the team managing these funds, as well as understanding how to diversify amongst risk categories.
The essentials of good business don’t change. When looking at a fund sheet (especially one that is ESG focused) it should be composed of known businesses that deliver reliable performance. ESG factors work best for investors when it’s in the hands of experienced, proven managers of business.
While you can exclude the obvious laggards, a good balance can provide growth especially as the ESG potentials (the ones that currently score just average of slightly above in ESG rankings) will become more attractive as the rewards to their efforts begin to be realized. It must be said, ESG investing is definitely not for short term gains – a medium to long term view is necessary as the investing world shifts its capital towards businesses that deliver in this area.
To date, there isn’t a replacement for size and experience, and one of the world’s largest ESG providers is Morgan Stanley Capital International (MSCI). Many funds rely on MSCI’s half a century of expertise and experience in research, data and technology. This is what some of the world’s best ESG focused investment strategists rely on to create insightful and transparent solutions for their clients. For the ordinary investor, they also publish a blog which has a wealth of information and is an excellent way to learn and be updated about the world of ESG investing. You can find it here.
This is where the ‘magic sauce’ so to speak can be found. The best tools are nothing if not wielded by experts. If you’re looking for a fund to invest in, this is certainly one of the key factors. Look for a dedicated team, and their related experiences.
While you can’t tell the future solely by looking into the past, backtesting is an important part of the process, as well as the way a fund would ‘learn’ a sector. When considering a new fund, always ask for the results of backtesting. Do note, it’s not always about the highest end result, but the most stable and sustainable returns that are usually more important. Remember that spikes of performance can also be driven by funds that unfortunately chase trends or bubbles.
When comparing funds, there are many measurements. The inventors of some of these include world renowned mathematicians, statisticians and noble prize winners. Even then, these come with a caution – they don’t always work.
Granted, you won’t get the best returns − but neither do you hold the highest levels of risk either. Stable, above average returns (look at investors like Berkshire Hathaway for inspiration) are always the best over the long run.
This is where ratings such as those provided by companies like Morningstar, or the sector exposure (which you can easily find on fund fact sheets) become more important as considerations. Are you comfortable with the sectors the fund is exposed to? Do the names of the companies in the top 10 holdings inspire you? These are the questions you should ask yourself.
Knowing some of these answers also helps the investments professionals recommend and shape the choices you’ll make that can help deliver the portfolio performance you want.