Environmental, Social & Governance (ESG) Investing Characteristics
The key to understanding sustainable investing today is to appreciate how it has evolved from its origins. Rather than maintaining the solely exclusionary processes of past iterations, Sustainable Investing strategies invest using an integrated approach that combines bottom-up analysis of both the financial and Environmental, Social and Governance (ESG) characteristics of a company. These Sustainable Investing strategies are inherently actively managed. The potential benefits of including ESG characteristics are grounded in intuition and supported by academic research.
With greater recognition of the benefits of Sustainable Investing, investors are showing increased interest in it. As asset managers work to meet this burgeoning demand, the number of strategies being offered in the marketplace is also growing. Given the relative nascence of the topic, a confusing overlap of terminologies and a rapid build-out in the product set, Sustainable Investing can present unique challenges from an investment due diligence perspective. Despite these hurdles, more investors are beginning to recognize the opportunity it may present.
ESG-Related Terms & Definitions
The range of terms used to describe strategies that focus on some form of values and sustainability integration can be bewildering at times. Terminology and definitions often vary slightly depending on the source or speaker.
- Ethical Investing2 – Investment philosophy guided by morals, ethics or religious beliefs in which investment decisions include non-economic criteria. The practice is traditionally associated with exclusionary screening.
- Socially Responsible Investing (SRI)2 - Similar to ethical investing in that it may involve trade-offs between social and financial performance. Seeks to minimize negative social impact by predominantly using exclusionary screens.
- Impact Investing3 – Discipline that combines consideration of financial performance with social and environmental performance. Distinguished from SRI by allocating capital and engaging company management to actively produce positive social impact.
- Environmental, Social and Corporate Governance (ESG) Criteria2 – A variety of issues that investors consider in the context of corporate behavior. Though no definitive list of ESG issues exists, they often include issues that have traditionally been considered non-financial and have a focus on a changing regulatory environment, the public-concern or supply-chain management.
- Sustainable Investing – The integration of ESG considerations into the investment management process with the objective of creating positive financial impact for investors.
Ethical & Moral Investment Strategies
The roots of ethical investing, which is the practice of excluding certain investments on religious or moral grounds, date back hundreds of years. In fact, in colonial America some religious groups avoided investing their endowments in institutions that supported the slave trade1. Similar investment practices continued through the 20th century, as some investors avoided investment in alcohol, tobacco and gambling due to religious or moral objections. As religious and moral considerations were specific to each investor, ethical investing was a highly customized investment practice. The first step in bringing these types of strategies to a broader investor base came in 1971 with the launch of the first ethically responsible mutual fund. The timing was not accidental. At the height of the Vietnam War and the beginning of the environmental movement, interest in ethical avoidance gained relevance beyond religious considerations.
During the 1970s, Socially Responsible Investing (SRI) began to take hold as a stand-alone investment concept based on ethical and moral exclusions and subsequently became a catch-all term to describe any investment process using exclusionary screens based on religious, environmental and ethical beliefs4. From the 1970s through the 1990s, SRI strategies experienced some success in gathering assets. By the mid-1990s there were about 60 distinct SRI mutual funds that managed around $640 billion5. However, the perception of SRI quickly focused on its exclusionary practices. It was widely debated whether the blanket exclusion of sectors or industries led to lower returns. As a result, SRI strategies gained limited appeal among investment professionals due to the perspective that investment performance would be hampered.
How ESG Standards & Principles Transform the Investment Landscape
In the early 2000s, however, investors began to acknowledge that certain environmental, social and governance (ESG) issues that were typically not included in traditional financial analysis materially affected corporate performance and, ultimately, returns to investors. In an effort to formalize certain ESG standards and goals, the United Nations introduced the Principles for Responsible Investing (UNPRI) in April 2006. UNPRI is a voluntary initiative in which signatories agree to incorporate six principles into their investment processes6.
UNPRI Signatories commit to:
- Incorporating ESG issues into investment analysis and decision-making processes.
- Being active owners and incorporating ESG issues into ownership policies and practices.
- Seeking appropriate disclosure on ESG issues by the entities in which they invest.
- Promoting acceptance and implementation of the principles within the investment industry.
- Working together to enhance effectiveness in implementing the principles.
- Reporting on activities and progress toward implementing the principles.
Additionally, signatories publicly assert their adherence to these six principles through the United Nations’ PRI list of signatories. As of March 31, 2019, there were over 2,372 signatories with over $86 trillion in assets under management. Signatories included asset owners, investment managers and service providers7.
While there is no definitive list of ESG criteria that a signatory must evaluate, some example considerations are detailed below:
|Sample Issue||Potential Impact|
|"E" Environmental||Environmental Disclosure & Transparency
|Lower Regulatory & Reputational Risk
Save on Energy Costs
Reduce Environmental Liabilities
|"S" Social||Diversity, Labor and Human Rights Issues
Product Safety & Quality
Community Relations and Philanthropy
|Mitigate Litigation Risk
Create Brand Loyalty
Protect Standing in Communities
|"G" Goverance||Transparent Financial Disclosure
Reasonable Executive Compensation
|Improve Shareholder Relations
Lessen Headline Risk
Dampen Turnover of Personnel
A Modern Investment Discipline – Sustainable Investing Utilizing ESG Considerations
Consistent with the increased interest in utilizing ESG criteria, the industry underwent a change in focus during the early 2000s: exclusionary SRI gave way to Sustainable Investing,1 which is an integrated investment process that utilizes rigorous financial analysis and idea generation combined with a thorough assessment of ESG considerations. Like any investment discipline, Sustainable Investing is informed by a point of view that ESG characteristics can be used to evaluate what contributes to and detracts from investment performance over time. Similar to the perspective of a value-oriented investor who believes that low price/earnings ratios are critical to identifying attractive stocks, sustainable investors believe that strong ESG characteristics may improve a company’s operational and financial results.
Sustainability in Action
The differences between SRI and Sustainable Investing extend beyond the underlying philosophy to how the respective strategies are implemented. Socially Responsible investment disciplines seek to minimize negative social impact and, therefore, predominantly use exclusionary screens to eliminate investment in certain industries.
In contrast, actively managed Sustainable Investing strategies seek to identify companies possessing strong or improving ESG characteristics with the belief that such characteristics will ultimately lead to positive social and financial outcomes.
The inclusionary approach of a Sustainable Investing discipline requires different resources and a modified approach relative to exclusionary SRI disciplines. A rigorous Sustainable Investing strategy requires that a manager dive deeper, evaluating a company’s business practices, corporate governance structure and relationship with its workers and the broader community. This evaluation can entail direct discussion with company management, review of third party data and reports issued by governmental entities and non-governmental organizations, and/or participation in industry groups focused on sustainability issues. Ultimately, this type of fundamental research depends on transparent corporate disclosure. Recognizing the investor demand for improved disclosure, corporate leaders have improved their reporting on sustainability issues. A 2017 survey of companies worldwide indicated that 78 percent report on sustainability issues, up 44 percent since 20118 .
The depth of analysis on ESG elements and, by extension, the quality of resources dedicated to sustainability analysis are indicative of a manager’s commitment to a thorough and rigorous Sustainable Investing discipline. While the information gleaned from fundamental research on ESG characteristics directly supports the sustainability assessment, it can also be additive to the analysis of a company’s financial prospects. As such, it is important to assess not only the resources a manager devotes to sustainability analysis, but also how the sustainability assessment interacts with financial analysis as part of an integrated discipline.
Another key element of a Sustainable Investing discipline is shareholder engagement with company directors and management across a broad spectrum of activities including proxy voting, investor coalition building and participation in public policy initiatives. In fact, from 2016 through the first half of 2018, 219 institutional investors and investment managers representing assets of $1.8 trillion filed or co-filed shareholder resolutions9 . The engaged sustainable investor seeks to maintain an ongoing dialogue with company management that focuses on appropriate initiatives to directionally improve a company as it seeks greater sustainability, mutually beneficial social outcomes and financial performance. Like any element of an investment discipline, this active engagement requires the allocation of appropriate resources with an objective of long-term corporate value enhancement through improved ESG practices.
The Question of Performance
As with any investment approach, one of the measures of a Sustainable Investing discipline will be its performance. The question with respect to ESG elements is whether favorable ESG characteristics contribute to improvement in a company’s operational and financial performance. As stock price returns are largely a function of the underlying results of a company, one may expect that improvement of corporate operational and financial results would be reflected in the company’s stock price.
One could understand why strong ESG characteristics might be innately beneficial to a company’s operations. Consider a company that emphasizes ESG initiatives such as energy efficiency, appropriate compliance with environmental and regulatory requirements and strong corporate governance practices. All else being equal, such a company could logically anticipate relatively lower energy input costs and a lower risk of regulatory fines. Furthermore, the strong corporate governance could provide a better alignment of management incentives with shareholder interests, potentially resulting in shareholder-friendly actions such as dividends or share buybacks. Lower input costs, less regulatory risk and corporate actions that benefit shareholders – traditional financial analysis has long recognized these as characteristics of an attractive investment. By emphasizing these ESG elements, Sustainable Investing seeks to support and enhance traditional financial analysis to identify strong investment opportunities, while simultaneously supporting positive social outcomes.
This logic is supported by the historical performance of Sustainable Investing. Deutsche Bank conducted a review of more than 60 academic studies that analyzed the financial, operational and market performance of companies with strong ESG characteristics10 . The results were clear. Of the academic studies reviewed:
- 100% found evidence that companies with high ratings for ESG characteristics benefited from a lower cost of capital.
- 85% found evidence that these companies exhibited accounting-based outperformance (e.g., return on assets, return on equity, etc.)
- 89% found evidence that these companies exhibited market outperformance.
Deutsche Bank also reviewed academic studies related to the performance of SRI funds, the old regime of ethical investing. Interestingly, the clear evidence of a relationship between favorable ESG characteristics and market outperformance was not found when examining the returns of exclusionary SRI funds. Instead, 88 percent of the studies reviewed indicated mixed or neutral results. While the academic literature does not suggest market underperformance, the lack of definitive positive evidence is perhaps a driver of the indifference many investors have had toward the old style of exclusionary, SRI strategies.
Beyond the academic literature, perhaps the most powerful indication of the benefits of strong ESG characteristics is also the simplest: a comparison of the MSCI ACWI ESG Index11 with the MSCI ACWI Index, a global equity index which does not incorporate ESG criteria. The MSCI ACWI ESG Index is a subset of the ACWI Index. To construct the MSCI ACWI ESG Index, MSCI’s team of research analysts rates each MSCI ACWI Index constituent on ESG criteria, assessing factors such as governance, human rights, environmental impact and supply chain management. The MSCI ACWI ESG Index constituents were those companies with the highest ESG ratings which add up to 50 percent of the market capitalization of each ACWI sector. In this manner, MSCI isolated the stronger ESG companies within each sector and constructed the MSCI ACWI ESG Index that had sector weightings similar to the parent MSCI ACWI Index.
From its inception on October 1, 2007 through December 31, 2019, the MSCI ACWI ESG Index has generated outperformance relative to the MSCI ACWI Index, adding over 60 basis points annually to returns. In addition, it has exhibited lower total volatility and less downside risk as measured by maximum drawdown (i.e., the largest peak-to-trough decline in value).
Growth of $10,000: MSCI ACWI ESG vs. MSCI ACWI
October 1, 2007 - December 31, 2019
October 1, 2007 to December 31, 2019
|Number of Constituents||Return||Standard Deviation||Maximum Drawdown|
|MSCI ACWI ESG*||1,223||5.46%||15.85%||(53.13%)|
The indexes mentioned are unmanaged statistical composites. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
The performance study referenced above and others that assess the performance of large sets of securities or strategies draw broad conclusions about the correlation between ESG criteria and financial performance. As with the selection of any investment, investors should examine the credentials and capabilities of a prospective manager offering a Sustainable Investing strategy. Irrespective of the average results, variation among individual securities or managers can lead to vastly different outcomes, highlighting the importance of the manager due diligence process.
Growing Investor Demand
With increasing evidence supporting the actively managed investment benefits of incorporating ESG factors, investor attitudes about Sustainable Investing are changing. Based on a 2019 Morgan Stanley survey, 86 percent of individual investors believed that companies embracing ESG practices may potentially be more profitable and may be better long-term investments12.
Given this convergence of research and opinion, Sustainable Investing has received increased attention from investors. In fact, a 2018 study by the Forum for Sustainable and Responsible Investment found that, from 2016 to 2018, total U.S. assets that consider ESG factors in their investment analysis framework have increased from $8 trillion to over $11 trillion9. Reflecting an improved understanding of the benefits of incorporating ESG elements, this growth is also supported by a broader demographic shift toward more interest in the social outcomes pursued by the new collection of Sustainable Investing strategies.
Sustainable Investing Growth in the U.S. - ESG Incorporation
(January 1995 - January 2018)
Assessing Actively Managed Sustainable Investing Strategies
Given the burgeoning interest in this relatively nascent space, many investors are analyzing Sustainable Investing strategies for the first time. Like the assessment of any other investment strategy, the vetting process should focus on understanding what resources are available to support the strategy and how the Sustainable Investing discipline is defined and implemented in the context of an overall investment philosophy. Key considerations include:
- Does the strategy utilize exclusionary screens or fundamental analysis of ESG characteristics?
- What ESG characteristics are considered and how are they assessed?
- How does the discipline integrate sustainability analysis with traditional financial analysis?
- What is the quality and extent of resources dedicated to sustainability analysis?
- What is the manager’s experience in implementing a Sustainable Investing strategy?
- How does the asset manager engage with company management and drive improvement in a company’s ESG characteristics?
Final Thoughts on Sustainable Investing Strategies
Sustainable Investing is undergoing a transition from niche strategy to mainstream. For most of the 20th century, investors only had access to the exclusionary strategies associated with SRI. A counterintuitive approach and lack of clear performance benefits left many cynical about the benefits of such strategies. However, the early 2000s saw the arrival of Sustainable Investing, with its inclusive approach that integrated assessment of a company’s ESG characteristics with rigorous financial analysis. Research indicates that the integration of ESG elements into an investment discipline has been additive to returns. Such research has allayed many investors’ concerns regarding actively managed ESG investing. With changing demographics and the more central role that social concerns take in investors’ financial decisions, this new brand of Sustainable Investing has seen a dramatic growth in assets and demand for investment vehicles.
As with any rapidly growing area of interest, numerous new strategies have come to market in an attempt to capture the assets flowing into the Sustainable Investing space. Given the confusing overlap of terminology and the relative lack of maturity compared to more traditional asset classes, there is an even greater need for investors to distinguish among the various options to identify those managers with the resources, discipline and pedigree to effectively implement Sustainable Investing strategies.
The MSCI All Country World Index measures the equity market performance of developed and emerging markets.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI.
Index performance is not indicative of fund performance. The indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges.
1 Commonfund Institute (2013). From SRI to ESG: The Changing World of Responsible Investing. Retrieved from: http://www.commonfund.org
2 Mercer LLC (2007). The Language of Responsible Investment: An Industry Guide to Key Terms and Organizations.
3 J.P. Morgan Global Research (2010). Impact Investments: An Emerging Asset Class. Retrieved from: http://jpmorganchase.com
4 US SIF/The Forum for Sustainable and Responsible Investment (2016). Report on U.S. Sustainable Responsible and Impact Investing Trends 2016. Retrieved from: http://www.ussif.org/trends
5 US Social Investment Forum (2005). (Now known as US SIF/The Forum for Sustainable and Responsible Investment). Report on Social Responsible Investment Trends in the United States.
6 UN PRI (2014). Annual Report 2014. Retrieved from: http://www.unpri.org
7 UN PRI (2020). About the PRI 2020. Retrieved from: https://www.unpri.org/pri/an-introduction-to-responsible-investment
8 KPMG (2017). The Road Ahead, The KPMG Survey of Corporate Responsibility Reporting 2017. Retrieved from: https://home.kpmg.com
9 US SIF/The Forum for Sustainable and Responsible Investment (2018). Report on U.S. Sustainable Responsible and Impact Investing Trends 2018. Retrieved from: http://www.ussif.org/trends
10 Deutsche Bank Group (2012). Sustainable Investing: Establishing Long-Term Value and Performance.
11 The MSCI ACWI ESG Index is a capitalization weighted index that includes companies with high ESG ratings relative to their sector peers. The Index targets sector exposure similar to its parent index (MSCI ACWI) by including those companies with the highest ESG ratings that make up 50% of the adjusted market capitalization in each sector of the parent index. The MSCI ACWI ESG Index consists of large and mid-cap companies across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. ESG ratings are based on data from MSCI ESG Research, a team of 130 dedicated research analysts that assess a company based on a variety of ESG indicators including Governance, Human Rights, Supply Chain Management and Environment.
12 Morgan Stanley Institute for Sustainable Investing (2019). Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice. Retrieved from: http://www.morganstanley.com
Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in a Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit our mutual funds section.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
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