‘Responsible investing’ is becoming a mainstream movement, with more institutions evaluating Environmental, Social, and Governance (ESG) criteria when they screen potential investments. This is a development we are watching with great interest at Dynasty and it is a trend that we broadly support. But before we look at the pros and cons of ESG, let’s take a closer look at the concept.
ESG refers to three key criteria that investors can use to measure the sustainability and ethical impact of a proposed investment:
- Environmental factors to evaluate how well a company performs as a steward of nature – for example, its impact in terms of carbon emissions, pollution, and deforestation;
- Social factors, such as diversity, working conditions, and health and safety; and
- Governance, dealing with factors such as the tax strategy, audits, internal controls, shareholder rights, and executive remuneration.
ESG isn’t a new abbreviation or concept – it has been around at least as far back as the IFC’s Who Cares Wins conference in 2005. But ESG has taken on a fresh urgency in recent years, with global and South African institutions all scrambling to burnish their responsible investment credentials.
According to Morningstar, net ESG fund inflows reached $51.1 billion in 2020, compared to just $21.4 billion in 2019 and $5.4 billion in 2018.
A groundswell of support
So, what’s behind the groundswell of support for responsible investing? Corporate scandals are certainly one factor. Some investors are beginning to see the logic of looking at ethical and sustainability indicators as closely as financial metrics in the wake of scandals such as Steinhoff and Tongaat Hulett in South Africa and Volkswagen and Boeing internationally.
Another driver for ESG at the institutional level is demand from retail investment customers. Many members of Generations Y and Z look for employers that share their values around sustainability and social issues, and these concerns weigh on their investment choices too. ESG is likely to become ever more important as these generations grow to be a bigger portion of the investment universe.
The Covid-19 pandemic has helped to accelerate the ESG trend. With a global health and humanitarian crisis tearing through markets, priorities are shifting and many consumers, institutions and regulators have upped their focus on ESG investing. A shift in the global political landscape is also contributing. Goldman Sachs says ESG is ‘no longer optional’ for asset managers, due to increased regulation in Europe and US President Joe Biden’s drive for sustainable business.
It’s important to note that few institutional investors still embrace the argument that their fiduciary duty is limited to the maximisation of shareholder value – in fact, they see ESG as complementing this primary mandate. They are beginning to see a role for themselves in blocking the funding of socially and environmentally destructive enterprises.
In the past, there was a perception that investing with ESG in mind meant trade-offs against maximising shareholder value. The reality is that ESG can often preserve and create value – for example, an ESG sensitive investor may have avoided bets on Volkswagen, which took a beating as a result of the Dieselgate scandal.
ESG performance often aligns with financial performance
In reality a company that meets ESG investment criteria is often a well-run enterprise from other points of view, too. In today’s world – where transparency is valued and social outlooks are changing – it may be better equipped to avoid risks to shareholder value such as regulatory battles and reputational scandals.
That’s not to say that there are no downsides to ESG. Depending on how narrowly the criteria are defined, it can restrict the universe of potential stocks an investor can choose from. There may be some good performers that don’t meet the benchmarks, for example, some ESG indexes do not include Amazon, which is one of the most successful and valuable companies in the world.
Plus, there is a danger that the clamour for ESG funds could distort pricing of assets in the market. Some investors might also not be aware that they’re duplicating exposure to the same stocks when they have an ESG fund or index tracker, in addition to a more general tracker following the 500 or Nasdaq indices.
Though we are not stock pickers, we believe that there is a strong overlap between the ESG criteria and sustainable long-term returns, and it is pleasing that our preferred active managers are sending the same message as reflected in their portfolio positioning.