Over the past several years, interest in ESG investments has exploded. For investors who are unfamiliar with this acronym, ESG stands for Environmental, Social and Corporate governance. They are also called "sustainable investments" or "ethical investments". During the early stages of my career, they were termed SRI or Socially Responsible Investments.
According to Morningstar, assets under management in ESG funds have ballooned to an estimated $23 trillion, an increase of more than 600% over the past decade. Currently, there are approximately 275 ESG open end mutual funds and ETFs available to interested investors.
There are two distinct trends that continue to drive assets towards ESG investments. According to recent statistics, millennials are twice as likely to embrace ESG standards than the rest of the investment public. Also, despite the fact that the Department of Labor initiative to impose the fiduciary standard on retirement accounts has ended, this movement continues to gain traction and supporters are pushing for its inclusion in all fee based portfolios.
The beginning of ESG investments can be traced to the 1950s and 1960s when some union pension plans decided to focus on investments that would have a positive impact on their members' lives. In the 1970s, the focus shifted and became more exclusionary by shunning companies located or doing business in South Africa during the apartheid regime as well as eschewing investments in utilities that operated nuclear power plants. Over time, this list expanded to eliminate companies involved in tobacco, gambling, alcohol and weapons as well as firms guilty of repeated and severe environmental infractions.
More recently, there has been a shift back to more inclusionary factors. In particular, companies with strong records on employee relations and environmental sustainability have been added to the mix. Despite this broadening of the selection process, the proportion of ESG fund assets aimed at companies with positive factors is only about 25%.
An ongoing problem that calls into question the benefit of applying ESG factors to evaluating companies is the lack of universally accepted standards. Sustainalytics was the first firm to evaluate ESG performance of companies 25 years ago. More recently, Morningstar began its sustainability rating process that applies ESG factors to uncover companies with unacceptable practices while identifying companies with specific risks. But without a generally accepted standard, ESG can mean different things to different people. For example, a company that manufactures or distributes birth control pills might be considered socially acceptable by one group but not another. Also, some companies have been known to exaggerate or misrepresent their ESG credentials in an effort to be included and expand their appeal to socially conscious investors.
Perhaps the greatest debate that continues to rage is the comparative performance of ESG to non ESG investments. For years, it was generally accepted that ESG investments under-performed the market. However, Lipper recently analyzed the performance of 535 ESG equity mutual funds (almost double the number categorized by Morningstar) and 28,813 non ESG funds. According to Lipper, performance was essentially identical in 2017 at 21.7%. In 2016, ESG equity funds produced an average return of 7.73% vs. 6.64% for non ESG funds. In my view, these performance numbers should be viewed with extreme skepticism since the significant number of non ESG funds includes many mediocre or sub-par performers which adversely skews these returns.
Whether or not investors choose to include ESG investments in their portfolio, it is apparent that interest will continue to grow and ESG factors may become a routine screen for many future asset allocation models.
Have a great remainder of the summer!