There’s a growing interest in environmental, social and governance (ESG) investment throughout the world. Ethical investing has been around for many years, but what’s driving the current trend and what does the future hold?

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Sustainability is a welcome trend in consumer advocacy and policy direction. It’s at the forefront of policy discussions, big business and environmental groups worldwide. The shift towards a sustainable and ethical future is making an impact on the investment landscape – and we’re all better off for it.

While the media narratives might suggest the younger generations are spurring the change, it’s not all driven by millennials. A dive into what’s actually driving ESG investing yields some surprising results.

What is ESG, SRI and ethical investing

Ethical investing is a catch-all term for practices concerned with investing in companies that align with ethical and social values. It has a long history starting with the Quakers in the 18th century. Ethical investing involves abstaining from investing in businesses considered to be morally questionable or socially harmful. It’s a subjective practice – one investor’s view of what is ethical might conflict with another’s.

Socially responsible investing (SRI) is also a broad definition of investment practices focused on funds that progress social causes and “do good”. SRI investing focuses on “screening in” investments that foster social good.

ESG brings together all the above by identifying companies that have high ESG scores. This style of investing is more concerned with company implementation of ESG principles. ESG factors include things like trust, innovation, climate change policy, management and employee development. Importantly, ESG investors do not expect to see a performance or cost penalty to this strategy when compared to conventional investing.

Research is starting to show that ESG investing could in fact be a dimension of higher expected return. Positive ESG factors seem to indicate well run companies with future-proofed business models. As a long-term investor, these are the companies you want to invest in.

What are the factors driving investment?

Traditionally, ethical investing was focused on avoiding companies based on negative screening. Companies that advanced negative factors such as pollution, scandals, unhealthy living and war were excluded from portfolios. The natural progression of ethical investing led to positive screening. Including companies focused on human rights, sustainability and peace meant better returns and less risk of association with negative companies through investment.

Now data providers and ratings agencies compile detailed scorecards on all listed companies around the world to rate them on ESG factors. These ratings databases allow a quantitative passive style of investing where screens or tilts are applied to “screen out” low scoring companies and “screen in” high scoring companies.

Estimations now put ESG assets under management at over $20 trillion. Over 80% of the world’s biggest corporations use GRI standards for sustainability reporting. So, who’s driving the change?

Institutions lead the way

While it may be argued that sustainability is simply the zeitgeist of our modern world, the financial drivers of ESG investing have been large pension funds, sovereign funds and institutions.

In 2017, the largest pension fund in the world – Japan’s GPIF – chose three ESG indexes for its passive investments. Dutch pension fund ABP, the second largest in Europe, has set itself the goals of reducing its equity portfolio’s carbon footprint by 25% and investing €5 billion in renewable energy by 2020.

The world is moving towards a greener future. People retiring in 20 to 50 years will be accessing their pensions in that future, so it makes sense for institutions to turn their portfolios towards ESG investments.

In addition to this, avoiding environmental and social scandals is easier with companies that hold positive ESG principles. Investors don’t want to be guilty by association, and it makes financial sense to move away from companies prone to these incidents.

ESG in the future

Numerous academic studies over the last five years have clearly shown the emergence of an “ESG premium” (a dimension of higher expected return). ESG is now clearly an important factor in future investment returns. We introduced our first ESG-specific portfolio models in 2018, and we’re in the process of bringing ESG tilts into all our portfolios. Data is showing that, although these filters result in slightly reduced diversification, ESG integration is a financially sound decision that is justified on a risk adjusted basis.

If you’re interested in discussing the role of ESG investing in your portfolio, speak to a cross-border wealth planning expert at Sable Wealth.

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