The investment landscape has changed radically over the past two decades from investors owning a portfolio of individual stocks to holding a portfolio of non-transparent mutual funds and broad-based index funds. More and more, investors are starting to ask the question: What type of companies am I investing in and how are they helping or hurting the environment, society, and the issues that I care about? This has resulted in the rise of Environmental, Social, and Governance investing (ESG) investing.
While profits and earnings growth are key to the investment decision making process, ESG also considers how companies are helping or hurting the environment, what their corporate culture is, and how they treat their employees as equally important.
Historically this has been referred to as socially responsible investing. However, there haven’t been many products available for investors who wanted to go this route. Typically, what was available to investors significantly underperformed non socially responsible alternatives. This resulted in making a rather difficult decision; either invest according to my values and make less money or hold my nose and just be happy that I am making more money. In 2005 this area was rebranded as ESG and since then more and more investment alternatives continue to be launched. Today, ESG investing has been estimated at over $20 trillion and growing. Investors no longer have to sacrifice their values for financial returns. In fact, they now can create just about any risk/return stream that they want, while still investing according to their values. This is going to create two massive shifts that financial advisors need to be aware of:
- If investors are presented with two options, both of which would probably produce the same returns, one is ESG and the other is not, then all things being equal they will likely choose the ESG option.
- As more and more investors choose the ESG option then more and more money will flow into those companies’ stocks. Indeed, ESG will become a true investing factor and companies that are ESG friendly will trade at a premium to companies that are not.
If your clients haven’t started asking you about ESG they soon will. If you are not well versed on the topic you will be missing out from the standpoint of being able to help clients create a portfolio that aligns with their values. You will also be missing out on participating in a major new investing factor as companies that are ESG friendly outperform companies that are not.
The ESG space still has a lot of room to grow because it hasn’t yet been completely embraced by institutional investors that believe it doesn’t fall under their fiduciary responsibility. However, pressure from clients and the performance of ESG companies will change this perception. We will also continue to see innovation and new products around areas where there are not yet a lot of alternatives, like bond funds and small cap stocks, among other investment sectors. This will allow investors to construct an entire asset allocation that is ESG friendly. We will also start to see the E, S, and G separated so that investors who predominately care about the environment can focus investments in “E”, while another investor who primarily cares about social issues can focus on “S”.
Some other roadblocks have been a lack of data on ESG issues and no real conformity on what makes a company ESG friendly. While companies are required to report financial information to shareholders, there is no such requirement on ESG issues. There can also be significant debate about whether a company is ESG friendly or not. As the industry continues to develop demand from investors will create more uniformity in these areas and they will become less and less of an issue.
One reason why many financial advisors may have ignored ESG is that they mistakenly believe it is only a fad among Millennials. However, an article in the Wall Street Journal
points out that it is actually Generation X (ages 39-54) that is driving the popularity of ESG. The article notes that last year, 63% of high-net-worth Gen X investors reviewed their portfolio for ESG investments, up from 36% in 2013. Remember that these are the same Gen X investors who are about to experience the largest wealth transfer in history as the baby boomer generation starts to die off.
Let’s face it, ESG investing is not a fad! I believe that it will continue to grow In popularity and as it does the financial advisors who don’t understand it, and the companies that don’t embrace, it will be left behind.