ESG: Goodness Should Be Baked In

Family Office Alpha Report

By Phoebe Outerbridge & Keith Danko

July 9, 2019

What do ESG investing and the Ford Model T have in common? A hint: it’s about process.

There was once the notion that returns from impact or ESG investing were concessionary, that these returns must come with a premium, and that it was a more “expensive” investment. This is rapidly becoming an antiquated myth. The inexorable march toward more enlightened investing is well underway, and is here to stay.

The automobile in the early 20th century was similarly regarded a premium investment, a specialty for the wealthy. Achieving any true return or efficiency from it was a secondary consideration, if even a consideration at all. Henry Ford had the vision to see that it was exactly the opposite: the automobile should be a machine of great utility created at a price point that made it an accessible product for everyone. His assembly line model of mass production not only saved industrial businesses (and Americans) money through efficiencies but also helped create better and better cars. There was no turning back.

Like the car assembly line became after 1908, impact investing is on its way to becoming the new normal. The term “impact” as it is currently understood now will lose relevance and will effectively become obsolete in the parlance of the investment world. One could argue “impact investing” itself (and its other names like socially responsible investing/SRI) is a redundant term akin to “general consensus.” Is there such a thing as investing without the goal of some form of impact? And who wants “irresponsible investing?”

For any business to remain profitable and relevant, it will need to impact our environment less, have a more diverse workforce and company leadership, provide fair and equal pay, and even more importantly, have more transparent governance (the “G” in ESG). If a publicly traded business lags in these efforts so too will its bottom line, as its peers adopting these changes will forge ahead. ESG is no longer icing on the cake, it’s fully baked in the cake. Shareholders will demand its implementation since it reflects their values. Witness the UBER strike this spring by workers demanding fair pay, and its ramifications: stock price losses were among the biggest in our country’s IPO history.

The ESG framework is already well in place. Nearly all S&P 500 companies—85% of them—now voluntarily issue a sustainability report. Though sustainability is a key value driver, many companies do not highlight this to the investing public, leaving many to think that any ESG issues are divorced from the topic of value and revenues. ESG factors are not only material but also essential to the financial performance of any company.

Why is impact an inherent element to alpha? In the case of environmental impact, it’s fairly simple: reducing inputs like energy and other resources helps drive profits and returns. In this way ESG issues directly affect financial performance. Also, investing with ESG screens and metrics can help reveal any flaws in governance or environmental practices, as these are non-financial KPIs which may not be otherwise revealed in analysis. Increased transparency helps to reduce risk.

According to Natixis Investment Managers, 55% of investors plan to increase their allocation to ESG in 2019; one-third of these investors also think ESG will become the norm in the next five years. Investors know that companies’ externalities affect the world. Managers must integrate ESG and sustainable investing practices and start incorporating these nonmaterial factors into their models and conversations with CEOs and CFOs, and should realize that strong demand to do so is coming from their investor base.  Consumers are demanding and will further demand this change as well: studies show we are willing to pay more for goods aligned with positive values.

“Increasingly, the asset allocator community is recognizing that investing responsibly and sustainably is a better way to optimize returns, reduce risks, and identify opportunities for future growth, all while aligning portfolios with broader social and environmental concerns of stakeholders,” said Scott Kalb, founder and director of RAAI and chair of Sovereign Investor Institute (part of Institutional Investor), in a statement accompanying The Responsible Asset Allocator Initiative report, which ranks the most responsible asset allocators in the world.

Regulations may also drive ESG/impact toward standardization, especially when it comes to environmental concerns. Our planet has a growing number of intractable challenges that need to be addressed. Climate change alone could be its own asset class, its risks creating major economic impact in our lifetimes.

The exponential rise in SRI-related investments is testimony that ESG/SRI/impact investing is here to stay: investments are growing at nearly 40% year over year since 2016, with more than $12 trillion–25% of total AUM–invested in a variety of socially responsible ways. Globally, Europe is well ahead of Canada and the US, with 50% of its AUM invested sustainably (versus 33% and 25% respectively). Major PE managers are already on the bandwagon (Blackstone, Bain, Goldman Sachs, Partners Group), and the 2015 implementation of the United Nation’s 17 Sustainable Development Goals marked a major milestone in the evolution of impact investing. While there are still some challenges related to reporting standards and benchmarking success, ESG is well on its way from being niche to the norm.