Historically, environmental, social and governance (ESG) investing was about excluding stocks of undesirable companies from portfolios — often because they violated one’s sense of ethics or values. ESG investing has since expanded to include consideration of ESG criteria alongside financial ones. ESG is growing in importance among institutional, wealth and retail investors. In recent years, institutional and high-net-worth investors’ adoption of ESG, along with the subsequent growth in ESG assets under management, has accelerated.1
We’ve seen three primary drivers for growth in ESG investment.
- The world is changing: Global sustainability challenges — such as flood risk and sea-level rise, privacy and data security, demographic shifts and regulatory pressures — are introducing new risks for investors. As companies face rising complexity globally, the modern investor may seek to re-evaluate traditional investment approaches.
- A new generation of investors is emerging: Over the next two to three decades, the millennial generation could put between $15 trillion and $20 trillion into U.S.-domiciled ESG investments, which would roughly double the size of the current U.S. equity market.2 A growing body of studies suggest that millennials — as well as women — are asking more of their investments.3
- Data and analytics are evolving: With better data from companies combined with better ESG research and analytics capabilities, we are seeing more systematic, quantitative, objective and financially relevant approaches to ESG investing.
But some investors are still seeking a comfort level with ESG investing. Recent studies by MSCI researchers have explored whether ESG characteristics have led to financially significant effects. In “Foundations of ESG Investing,’’ our researchers examined how ESG related to the valuation and performance of companies, both through their systematic profile (have companies with strong ESG characteristics shown a lower cost of capital and higher valuations?) and through their idiosyncratic risk profile (have they experienced higher profitability and lower exposure to tail risk?). Specifically, in relation to the stock-specific risks, our researchers saw that companies in the bottom fifth (by ESG score) of the MSCI World Index experienced large drawdowns (above 95%) three times higher than those in the top fifth throughout the study period from January 2007 to May 2017.4
How can investors best navigate through the maze of ESG solutions, mutual funds, ETFs and separately managed accounts that are available today? Can advisers help their clients align their ESG beliefs to create an integrated ESG portfolio solution that is reflected in their asset allocation? One way might be through model portfolios. These pre-packaged asset-allocation models can be used by institutions to help their clients integrate their ESG beliefs. We provide three examples of such models below:
- Asset allocation aligned with personal values:
Some investors may consider ESG considerations a means for aligning investments with their ethical, religious or political beliefs. This may include screens for controversial activities such as tobacco, weapons, alcohol or gambling.
- Asset allocation aligned with positive impact::
Some investors may be focused on making a strong impact on the world. They may seek to direct their capital toward companies that provide solutions to environmental or social challenges and through formal frameworks such as the UN Sustainable Development Goals (SDGs).
- Asset allocation aligned with ESG integration:
Finally, some investors may look at ESG criteria as a way to manage these risks and to achieve long-term sustainable financial performance.
We anticipate that ESG issues will only continue to grow and further impact our economy and society globally. While there are an increasing number of studies showing a positive correlation between ESG and performance,5 investors may wish to engage in their own diligence to decide whether and how ESG may fit into their investment processes. Recent developments have increased the range of options available to investors, offering a variety of choices to implement their specific approach to integrating ESG into their portfolios.
1See Field, A. “SRI Investing in the US Now $12 Trillion In AUM.” Forbes. Nov. 26, 2018; Kilroy, M. “SRI Investing In The US Now $12 Trillion In AUM.” Pensions & Investments. Sept. 3, 2018; and Chandler, B. “Cerulli reports ESG demand is growing.” Wealthadviser. Dec. 17, 2018.
2“Introducing ESG Investing.” MSCI.
3For example, see Abou-Jaoudé, N. “Millennials and women key drivers of socially responsible investment.” EuropeanCEO. Sept. 25, 2018; and Chatzky, J. “How millennials are changing the way we invest.” NBC News. Nov. 14, 2018.
4 MSCI World Index, January 2007 to May 2017. Note: We use a full three-year look-ahead window in reporting results. For each month, we report the number of stocks that realized a more than 95% cumulative loss over the next three years, taking the price at month end as the reference point for the return calculation. Thus, the last data point is from May 2014.
5 See “Foundations of ESG Investing” for a summary of the literature.