Dissecting ESG: Ethics and Profitability

22 February 2019
By Rosie Guest, Global Marketing Director at Apex Fund Services
green heart and gold coins on bamboo scale
green heart and gold coins on bamboo scale

Today, ESG investing – so-called from its focus on Environmental, Social and Governance factors – has become the most popular of the many different types of Sustainable Investing (SI) strategies. Despite its popularity, however, there can be confusion over what ESG entails and how it differs from other SI approaches.

ESG takes into consideration the social, environmental and governance impacts of investments, yet is still focused on financial performance and generating positive returns. It is often referred to as “norms-based” investing/screening. Norms-based screening ensures that investors have the ability to investigate a firm’s policies and procedures regarding ethics and responsibility. The European Sustainable Investment Forum (Eurosif) describes norms-based screening as the “screening of investment according to their compliance with international standards and norms”.

ESG investments are different from other SI strategies such as ‘impact investments’ and ‘philanthropic investments’ in the weighting of priorities. While ESG places an equal weight on ethics and on profitability, an impact strategy ranks the a positive influence on society and/or the environment higher than financial gain, but still factors profit as a positive attribute. Philanthropic modes of investing deemphasize profit even further, regarding it as essentially inconsequential.

Its evenly weighted focus on ethics and profitability means that ESG slots well into the asset management space in the age of the millennial, providing an ethical and responsible way of investing whilst generating returns.

The Facts and Growth Stats

In 2016 the Global Sustainable Investment Alliance suggested in its report that there were $22.89 trillion of assets being professionally managed under “responsible investment strategies”—a 25 percent increase since 2014. The trend toward diversification and the growth of the hybrid fund also furthers the need for ESG on a global basis, as does the emphasis that both regulators and investors are placing on transparency of fund governance. Such transparency shines a bright light on a fund’s ESG strategy—or lack of one. And younger investors are taking notice.

As a result, many firms are adding asset managers with ESG competencies and are improving their ability to disclose ESG indicators—which often positively impacts long-term profitability. So it is that a genuine investment rationale, combined with the need to demonstrate a responsible investment methodology in an increasingly socially and environmentally aware world, that is propelling ESG forward.

Sustainability is Key

Complexities in regulation, pollution, political unrest, migration, weather disruption and other factors are combining in a perfect storm of global change. The increasing global nature of asset management only increases the influence of these factors and the subsequent risks, as what might have been previously localised issues take on global impact magnified by the growth of multi-jurisdiction investing and multi-asset strategies.

ESG is ideally suited for this environment. As JP Morgan stated in a 2016 report on ESG investing, “not having ESG factors in your portfolio significantly increases volatility, lowers potential Sharpe ratios and leads to a higher probability of suffering larger drawdowns during times of market stress”. Identifying better-managed companies in which to invest ultimately acts to moderate risk and enhance long-term sustainability in financial performance. Similarly, a 2017 CFA Institute survey of more than 1,300 financial advisors and research analysts found that 73 percent take ESG issues into account in their investment analysis and decisions. Our own informal poll taken at a recent Apex ESG event held in New York in June 2018, found that 84 percent of respondents stated the same (see below). The CFA survey strongly demonstrated that the main reason for consideration for integrating ESG into investment analysis and decisions came from investor and client demand, with 66 percent stating that as the core driver.

green heart and gold coins on bamboo scale

ESG also enjoys growing interest from the private equity sector. Tim Hames, Director General of the British Private Equity and Venture Capital Association said, “The integration of ESG into a GP’s operations has been high on the industry’s agenda for some years now. Many firms have demonstrated that ESG integration can add value to a portfolio and there is growing support for adopting the Principles of Responsible Investment”.

We know that the current disruptive nature of the asset management space suits private equity managers. It makes sense, then, that this asset class is embracing ESG. The long-term view private equity managers take means that through ESG integration they can capitalise on the opportunity to create social value, improve the environment and in doing so, increase their financial returns.