Contributed by: Jaclyn Jackson, CAP®
*This blog was originally published on April 8, 2021. For more information on matching your values to your investments, check out The Center Social Strategy.
According to CNBC, almost 1 in 4 dollars is going into Environmental, Social, and Governance (ESG) funds this year. Even before 2021, the combination of ethical provisions and competitive performance turned many heads towards ESG investments. I aim to explain what the big fuss is about and why ESG investments are gaining traction.
Investors Are Talking About It
To be clear, the March 2020 downturn was no picnic (for anyone). However, investors who had stake in environmental, social, and governance (ESG) investments managed the economic downturn with greater resilience. Leading research firm, Morningstar, reported that during March 2020, “sustainable funds dominated the top quartiles and top halves of their peer groups. Sixty-six percent of sustainable equity funds ranked in the top halves of their respective categories and more than a third (39%) ranked in their category's best quartile.” Compared to peers, ESG funds pulled top rankings.
Not only did peer to peer comparisons look good, but index comparisons proved more robust too. In the same study, Morningstar compared 12 passive ESG funds in the large-blend category to a traditionally passive fund. They reported, “For the year through March 12, all 12 ESG index funds outperformed”. What’s more is that fees were included in this study. While the ESG passive funds compared were more expensive than the traditional passive fund, they still managed to outperform. Impressively, the trend held with international and emerging market index comparisons…and everybody is talking about it!
Including the world’s largest investor/asset manager, BlackRock, who’s CEO challenged corporations to consider the impact of climate change on business models. In 2020, CEO Larry Fink announced BlackRock would incorporate ESG metrics into 100% of their portfolios. The asset manager also pledged to produce data and analytics to punctuate why considering climate change should be an investment value.
Yellen And Powell Are Talking About It
Investors are not the only people concerned. In wake of recent natural disasters, Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell are working to assess the risks climate change poses to the health and resilience of the financial system. Their consensus implied a concentrated effort to monitor financial institutions and their exposure to extreme weather events. Leading the charge, Fed Governor Lael Brainard, recently announced the Financial Supervision Climate Committee (FSCC). Brainard is a proponent of using scenario testing to understand banks’ ability to survive hypothetical climate catastrophes. The FSCC will focus on developing evaluation processes for climate risks to the financial system.
Why Everybody Is Talking About It
While many people acknowledge the ethical appeal of ESG methodologies, they may not fully appreciate the businesses appeal that underpins stock performance. Business litigation risk provides a clear example. The Financial Analyst Journal featured a study that explored the relationship between ESG performance and company litigation risks. Analyzing US class action lawsuits, researchers found, “a 1 standard deviation improvement in the ESG controversies of an average company in the sample reduced litigation risk from 3.1% to 2.4%”. The study also asserted that companies with low ESG performance experienced market value losses ($1.14 billion) twice the size of companies with high ESG performance. Further, the study integrated their findings with a trading strategy and concluded investors benefitted from lower litigation risk.
It doesn’t stop with litigation risk. There are also links between healthy corporate governance and market returns. As You Sow, a nonprofit promoting corporate responsibility, has been tracking S&P 500 companies with excessively compensated CEOs since 2015. They collaborated with R. Paul Herman, CEO of HIP Investor Inc., to do performance analysis based on their tracking. Herman determined, “…shareholders could have avoided lagging returns by excluding companies that keep making the list for excessive CEO pay”. Companies without excessively paid CEOs significantly outperformed companies with excessively paid CEOs. The former generated 5.6% in annualized returns compared to the latter at 1.5%. What’s astonishing is that the report noted, “The performance gap due to excessive compensation equates to approximately $223 billion in shareholder value lost.” How are companies without overpaid CEOs edging out competitors? Instead of overpaying CEOs, more resources can be dedicated to research and development projects, dividends to shareholders, or equitable pay for employees; things that advantage company profits and support positive investor outcomes.
Are You Talking About It?
There is definitely a case for the merits of ESG investing. It is no wonder folks are talking about it. Are you interested in the conversation? If you’ve followed trends in ESG investing and are considering adapting ESG strategies into your portfolio, The Center is here to help. Ask your advisor about the Center Social Strategy; they would be happy to talk about it with you.
Jaclyn Jackson, CAP® is a Senior Portfolio Manager at Center for Financial Planning, Inc.® She manages client portfolios and performs investment research.
This material is provided for information purposes only and is not a complete description of the securities, markets, or developments referred to in this material. Any opinions are those of the author and not necessarily those of Raymond James. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Utilizing an ESG investment strategy may result in investment returns that may be lower or higher than if decisions were based solely on investment considerations. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results.
