Demand from investors lies at the heart of the current rise in including ESG, SRI and Impact Investing filters to investment products. Investors, particularly large institutional investors in the religious or educational sectors, care, and increasingly, they realise that they do not have to lose investment returns in order to invest with ethical considerations.
But the routes to include ESG or SRI factors in investment are less clear. A study earlier this year from American research firm Cerulli Associates, found that alternatives struggle in implementing ESG principles, despite being fully aware that this is what investors want.
Time horizons vary – ESG factors can take a long time to play out, while alternatives tend to invest for a shorter outcome, the firm noted. This piece of research found that reporting, lack of data and transparency were also issues for alternative managers seeking investments that pass the ESG challenge.
However, in the US, 90 per cent of US asset managers reported that ESG integration is a factor in their future product development plans, and some of Asia’s major institutions have started awarding ESG mandates, a development that Cerulli believes will prompt others to follow suit.
Using ETFs as a route to including ESG factors has also been studied by State Street Global Advisors, the asset management arm of State Street Corporation, whose latest research that reveals that 83 per cent of institutional investors and wealth managers expect flows into ESG ETFs to increase between now and 2023. Just over one in five (22.5 per cent) anticipated a dramatic rise.
The largest factor behind this growth was increasing demand from investors, followed by an overall increase in demand for ESG strategies, which accounted for 28 per cent of respondents. One in four (25 per cent) say demand for ESG ETFs will be driven by regulatory changes that make those strategies more appealing.
When asked which exclusions would make investors more likely to invest in an ESG ETF, 61 per cent said weapons manufacturers, followed by 44 per cent who pointed to fossil fuel companies. The same percentage cited organisations that conduct tests on animals.
When asked what inclusions would make investors more likely to select an ESG ETF, 66 per cent cited sustainable energy, followed by 39 per cent who selected habitat protection. More than one in four (26 per cent) said an ESG ETF with a focus on diversity would increase their chances of investing in it.
But that fear of ESG impacting on returns continues. Another study from Cerulli found that, for advisers, one of the biggest hurdles in turning interest into actual investment, both by users of ESG and non-users, is the perceived impact on investment performance.
The firm reports that among ESG users, only 19 per cent state that sustainable investment returns are a major factor driving their demand for ESG. On the opposite side of the fence, 35 per cent of advisers not currently using ESG note that a negative impact on investment performance is a significant factor preventing them from implementing ESG.
Data provider and analyst firm Morningstar published its report on the sector in May. ‘Passive Sustainable Funds: The Global Landscape,’ reviews trends in asset growth, asset flows, and product development of index-tracking sustainable funds and is designed to illuminate the choices currently available to investors worldwide.
Morningstar writes that as of 31 December 2017, there were nearly 270 sustainable index mutual funds and ETFs worldwide, with collective assets under management of approximately USD102 billion.
Morningstar’s figures found that passive sustainable funds’ market share has doubled globally from less than 6 per cent five years ago to about 12 per cent, coinciding with the overall trend towards passive investing and the development of more sophisticated indexes on the back of better environmental, social, and governance (ESG) data.
Growth across regions has not been uniform, Morningstar says. Over the past five years, US assets have quadrupled. European funds have dominated inflows over that same span and retain the lion’s share of assets—accounting for 85 per cent of the global total.
The firm writes that Europe’s dominance is largely supported by institutional investors with sustainable mandates, particularly Scandinavian public pension, sovereign wealth, and insurance funds.
Data based on indices such as the MSCI Emerging Markets Socially Responsible Investment index reveals performance of over 20 percentage points ahead of the MSCI EM index since its launch in mid-2011, based on Bloomberg data from May 31 2011 to April 30 2018.
And MSCI’s own research shows that it’s not just the G in ESG which makes ESG factored companies perform. The firm says that when it came to a select group of companies with excellent financial fundamentals, ESG information was more than just a proxy for strong governance.
“Better management of environmental and social risks and opportunities led to higher MSCI ESG Ratings, which, in turn, were associated with higher ROIC and valuation. In short, environmental and social scores provided an overlay investors may use to further differentiate performers, serving as a reminder that ESG is a tale told in three parts,” the firm writes.
And environmental concerns are also increasingly important. The UK Sustainable Investment and Finance Association (UKsif) and the Climate Change Collaboration have undertaken its second annual survey of fund managers and reports that the fund management sector is clear that International Oil Companies (IOCs) will be negatively revalued within a few years because of climate change related risks. The Association finds that 90 per cent of fund managers expect at least one risk to impact significantly the valuation of IOCs within two years.
According to this survey, the big risks include reputational damage because of their role in causing climate change; Litigation for losses from climate change; and Regulation to curtail fossil fuel pollution.
The transition of energy also poses risks, the survey says, as the increasing competitiveness of alternative energy technologies leads to a drop in demand for fossil fuels and a shift in market sentiment as investors lose faith in IOCs ability to transition in a financially successful manner.
This study found that 89 per cent of managers agreed that these and other transition risks would impact valuations of the IOCs ‘significantly’ in the next five years, and that these perceptions of risks have increased dramatically in the last 12 months.
The report found that since last year there is a doubling of investors that see transition risk significantly impacting IOCs in five years with the result that some respondents were planning to divest from IOCs if they didn’t see a material change in policy and behaviour.
And, again, investor demand was a significant driver of this change. The report found that 71 per cent of managers reported an increase in client interest in the last 12 months. And 15 of the total 30 managers already offer active funds or bespoke portfolios that have ‘Divested from (at least) the 200 coal, oil and gas companies with largest reserves’. Some 13 firms in the study offer active equity funds, and four others could. Three offer passive equity funds with the same criteria, and three more could. Five managers offer or will soon offer bond funds that are divested from the top 200, six others could.
The authors of this report say: “The fund management sector recognises the imminent risks posed to fossil fuel investments from climate change and the transition toward a zero-carbon economy.”
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