ESG And The New Viability
by P.E. KelleyMr. Kelley is the managing editor of this magazine. Connect with him by e-mail: firstname.lastname@example.org
How does the concept of sustainability translate into profitability for companies that embrace it? Does being green cultivate a new pathway toward market performance? While there is plenty of debate on the subject, portfolios containing companies that score high on environmental, social and governance issues have actually performed quite well. Moreover, they exhibit a curious ability to do so during periods of volatility.
We spoke with Ann Marie Etergino, a financial advisor with RBC Wealth Management, in Chevy Chase, Md. While she admitted that ESG is more of a philosophy than a financial metric, there are nonetheless specific fundamentals that drive it: a willingness to look beyond the balance sheet, the ability to build a portfolio that reflects investors’ unique goals and values, and, in the long run, fostering a holistic understanding of its risks and rewards.
PEK: What bridges the gap between ESG, which is fundamentally informed not so much by a financial perspective but a social one, and the notion that ESG investing can be viable… and presumably profitable?
AME: When it comes to investing, not everything that counts can be counted. Factors like culture, human capital, innovation, organizational health, speed of decision making are all critical aspects of the long-term viable success of a business, and yet you will not see any of them within traditional financial reporting.
Our view is that high ESG values create financial value. This positive link is also a cycle – for example, the first ESG initiatives within a corporation support financial performance, thereby increasing capital and resources to reinvest internally in additional or continued ESG initiatives. Over time, the ESG momentum builds. As the corporation becomes an even better ESG firm, financial performance keeps improving, and the cycle continues.
In addition, there have been a series of quantitative studies that have shown that corporations with high ESG ratings generally outperform and tend to be less volatile, including one by our RBC Global Asset Management (July 2019).
PEK: You’ve referenced an example of how, during a period during the 2018 S&P downturn, ’sustainable equity funds’ finished in the top quartile of their category. What were the particular make-up of these funds that might help illustrate the construction and viability of ESG funds?
AME: At its core, the goal of ESG investment analysis is to identify “responsible” companies, and allocate capital to them. These “responsible” companies are more likely to be engaged in sustainable activities or business practices, and as a result more likely to outperform their competitors in terms of both greater investment growth and lower volatility.
This spectrum of ESG factors that composed these “sustainable equity funds” highlights the importance of all three pillars of ESG investing – environmental, social, and governance – and also that the core tenets of ESG investing can be applied to all industries. In other words, it was not only environmental, or only governance, which supported these funds’ outperformance, but instead the application of all three.
PEK: There seems to be an emerging consensus that companies with strong corporate governance practices often tend to demonstrate lower volatility during downturns. Can you discuss the relationship at play between the boardrooms and Wall Street?
AME: We believe that a company that values and instills ESG principles is taking a long-term view, and this long-term view will cascade across the company to yield better decision-making, and consequently better long-term stability and success.
Furthermore, we believe that a company that values ESG principles will be better corporate risk managers. Company leaders will be more attuned to non-financial issues such as reputation, employee satisfaction, environmental impact, and social responsibility.
PEK: What are considered the fundamental traits of ESG investing… what’s inside a typical fund and how does it earn the ESG label?
AME: One fundamental trait of ESG investing is looking beyond the balance sheet during the investment decision making process. By incorporating ESG factors into your decision-making process, you can gain a deeper understanding of the potential returns and the potential risks of an investment. Furthermore, this insight allows you to better assess how a specific investment fits into your existing overall portfolio.
Another fundamental trait of ESG investing is creating and maintaining a portfolio that reflects the investor’s specific goals and values. These personalized portfolios reflect the values that are most important to the investor – from sustainable growth to environmentally-conscious business practices to emphasis on diversity and inclusion, all these ESG factors can be incorporated into a portfolio based on the investor’s personal values.
Putting it all together, integrating ESG factors into the investment decision making process fosters a more comprehensive and holistic understanding of an investment’s potential risks and returns, and helps investors design portfolio that reflect their unique goals and values.
PEK: Following that, can you discuss briefly the process of rating ESG investments by a specific ESG measurement, which might take into account things like an actual ‘ESG Performance index’, a ‘controversy score and a need for transparency in data analysis of ESG risk?
AME: Currently ESG is more of a philosophy than a financial metric. There are ESG indices available to investors, such as MSCI, which measure performance. In order for ESG to become a metric, the finance industry will need to clarify the definition of ESG as well as outline consistent standards for ESG compliance and performance.
PEK: Generally speaking, are there different expense-factors at play with companies within ESG investments, perhaps exhibiting a higher cost of equity, and how does that effect the perception of risk?
AME: Actively managed ESG funds often require more comprehensive initial analysis of investments, and then more thorough ongoing due diligence. As such, active ESG funds usually have high expense ratios, in order to support these more detailed investment reviews. As ESG investing has both increased in demand and evolved as a methodology, lower-cost and passively managed ESG funds were launched. Passively managed ESG funds have lower expense ratios than their actively managed counterparts – and some ESG index fees are competitive with more traditional index fees.
Specific to companies with high ESG values, our view is that corporations with high ESG values may in fact have a lower cost of capital. There are costs associated with low ESG firms, such as increased regulatory costs, lower productivity and lower demand for the company’s products.
For example, high corporate governance standards, which is one of the three core tenets of ESG investing, can reduce a firm’s default risk, thereby directly reducing its cost of capital. In addition, as investors are increasingly integrating ESG into their investment decision making process, companies with low ESG may have more limited access to capital than their high ESG peers.
Overall, ESG initiatives can support revenue generations, reduce costs, and thus positively impact financial performance.
PEK: What is the fundamental value-proposition that an advisor can craft in the sales approach; aside from a client’s personal attraction to ESG, how do you make sense of it as a viable investment?
AME: Our team’s philosophy of “Connecting Wealth with Purpose” goes hand-in-hand with ESG investing. We take great pride in the relationships we have built with individuals and organizations to design customized investment portfolios with the aim of achieving maximum risk-adjusted returns while also choosing investments that are aligned with our clients’ specific values and mission. This is the essence of ESG investing, as well as our client service model.
Our clients, and investors overall, are also pushing for ESG investing – these ESG factors are becoming increasingly important to the market. Environmental issues, such as climate change, are now more often presented as potentially systemic financial risks, and thus potential risks to the financial markets.
ESG investing is not new for our team – we have been working with clients for over a decade to structure their investment portfolios aligned with their values.
At the end of the day, our clients look to us to be exemplary stewards of capital, but also to generate risk-adjusted returns to help them reach their goals.