Contributed by: Jaclyn Jackson
As children, many of us were made familiar with The Little Engine That Could, a story about a small railroad engine that overcame the seemingly impossible challenge of pulling heavy freight cars up and over an intimidating mountain. As we witness the unraveling of many government policies, alliances, and programs helpful to ESG (Environmental, Social, Governance) investing such as dismantling carbon dioxide mitigation, leaving the Paris Agreement global pact, looming EPA budget cuts, etc., it would appear that an insurmountable amount of challenges could hurt ESG investment product performance.
Yet, like The Little Engine, the trend towards ESG investing is plugging ahead with great intensity. In fact, the recent focus on these issues has fired up investors and fund companies. Leading research firm, Morningstar, has seen a four-fold increase in the use of ESG data in its cloud-based research platform used by asset managers, advisory firms and independent wealth managers since Trump’s election. Net flows into ESG products in the first 6 months of 2017 have been greater than both 2014 and 2015. With a dozen new open-end sustainable mutual funds, 2017 flows are also positioned to beat 2016 numbers.
Performance
Excluding ethical motivations, ESG transparency helps investors get a unique, “under the hood” analysis of company risk (or stability) that complements traditional research methods. For example, ESG risks are sometimes more prominent in foreign markets (autocratic governments, human rights issues, wage disparities, etc.). The graph below demonstrates that ignoring ESG factors may lead to reduced returns for investors in emerging markets.
A study done by European Centre for Corporate Engagement (ECCE) also supports correlation between good ESG practices and financial performance for emerging-market companies. Even in the case of developed markets, Hermes' global equities team research found that avoiding companies with bottom-decile corporate governance rankings could increase returns by 30 basis points (bps) per month. To boot, research by index provider, MSCI, indicated that a company’s efforts towards sustainability, such as fair labor practices, good environmental stewardship, and diverse internal leadership, improves returns.
Is it Just Smart Business?
Going back to our metaphor, imagine that the Little Engine was little by design. While the Little Engine had fewer cylinders and less horse power, it also burned less fuel. Since the Little Engine was smaller, it weighed less and minimized wear and tear on the parts that supported it. Perhaps the company that owned or built the Little Engine designed it to save money on fuel, have fewer repairs, and prevent EPA emission fines from cutting into profits.
This begs the question, Are companies that manage environmental, social, and governance factors just practicing smart business strategy? Phil Davidson, co-manager of American Century Equity Income, stated it best in a Barron’s article, “Cutting corners on environmental issues, for instance, can lead to lawsuits, fines, and damages. Businesses that use less water and less power have lower costs and operate more efficiently. Good corporate governance plays a winning hand in capital allocation and is critical to corporate longevity. If a company is being managed for the short term to maximize revenue, that’s not sustainable.”
Here to Stay
Despite political noise, it seems some fund companies and investors alike continue to embrace ESG strategies. Research indicates monitoring risks factors that may affect the sustainability of a company may prove to support higher potential returns. Perhaps ESG strategies are finally “up the hill” as they seem to be a more common part of one’s investment strategy.
Jaclyn Jackson is a Portfolio Administrator and Financial Associate at Center for Financial Planning, Inc.®
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