How advisors are holistically adapting multi-asset portfolios to a changing ESG landscape
by Abdur Nimeri, Ph.D.Mr. Nimeri is head of Institutional Multi-Asset Programs, Northern Trust Asset Management. Visit www.northerntrust.com
I was born not knowing and have had only a little time to change that here and there – Richard Feynman
As the coronavirus pandemic forces governments and health care professionals to address several social-economic issues, investors are evaluating how they can make changes here and there.
The lexicon for “responsible investing,” a term that encompasses a multitude of investment strategies – Environmental, Social, and Governance (ESG) investing; Socially Responsible Investing; and Impact Investing – has come into sharp focus in recent months. The term ESG, and all it represents, has particularly grown in popularity and importance. ESG has become a lens through which many investors view companies and the way they utilize, engage and deploy their human capital.
Since March 2020, global market volatility, largely driven by the social and economic effects of the COVID-19 pandemic, has culminated in unprecedented layoffs/furloughs, government intervention and industry restructuring. Industries are adapting to a changing consumer base with less disposable income and less inclination to spend. Trillions of dollars have been committed to support global economies and to address the global health care systems’ shortcomings. And while it’s true that some industries have displayed more resilience than others, all have seen significant changes in how they are conducting business, from a greater reliance on work-from-home structures to working with smaller teams.
Moreover, this restructuring has led many, including retail and institutional investors, to think critically about several ESG issues. Many of the measures companies have enacted relate to employees’ engagement, support and flexibility, and are expected to result in greater retention and productivity. Intangible or non-financial ESG metrics like these have been gaining considerable interest and adoption among investors over the last several years. The pandemic has furthered this trend, to the point where many investors are demanding that their advisors align their investing strategies in a holistic manner with their everyday values.
In recent conversations with investment advisors, it has become apparent to me that companies should expect a greater deal of scrutiny and analysis beyond traditional financial metrics, such as price-earnings ratio and cash flow going forward. To be sure, companies are living up to greater social standards or expectations and many individual investors are seeking due diligence tools and techniques to realign their legacy portfolios (non-ESG focused) to better fit their personal goals.
Today, more than in recent years, many RIAs are asking the simple question, “How should, and could, I holistically align my clients’ investment portfolios with ESG factors?” They are no longer willing to ignore ESG risk. And, while ESG investing was once solely the domain of equity investing, there are now ESG options among bonds and other asset classes, so it has become a comprehensive component of multi-asset class investing.
ESG Funds Increasing to Meet Investor Interest
In 2019, Morningstar reported that “72% of the U.S. population expressed at least a moderate interest in sustainable investing, and—going against common stereotypes that ESG investors are mostly millennials and women—this population comprises investors of all ages and genders.”
Clearly, providing clients with a way to integrate ESG investments in their portfolios or even to create entire portfolios geared toward sustainable investments is a key to attracting and retaining such investors. In fact, in its Global Sustainable Fund Flows report published in May 2020, Morningstar reported that “sustainable funds globally attracted an estimated $45.7 billion in net flows during the first quarter of 2020 even as the overall fund universe suffered $384.7 billion in outflows.” This is continuing a multi-year trend. And to meet the demand, ESG funds are proliferating. In 2014, investors could choose from 111 funds in the sustainable universe. This number reached 303 and represented 67 different Morningstar categories as of December 2019.1
As previously noted, COVID-19 has put many ESG issues front and center, thereby leading to a greater number of investors becoming more aware of their investment choices and seeking ones which are aligned with their values. With such issues as climate change, diversity and inclusion, and executive compensation making headlines every day, investor interest in them will only increase. By providing ESG investment options and helping your clients understand the impact ESG can have on their portfolios, you can build positive relationships with clients who want to make a difference with their investments.
ESG As a Return Enhancer and Risk Mitigator
Of critical note: extensive research has shown that companies that score high on ESG metrics typically tend to fare better than those that do not. For example, in looking at the first half of this year, data from eVestment shows that for U.S. equities, the median ESG manager outperformed the median non-ESG manager by 4.91%. Outperformance among global equities was 2.89%. Hence, investors are not sacrificing return by aligning their portfolios with their values or conscience.
Companies that prioritize environmental, social and governance criteria are likely to create value in five essential ways according to a November 2019 McKinsey report, “5 ways that ESG creates value.” These include: top-line growth, cost reductions, regulatory and legal intervention, productivity uplifts, and investment and asset optimization. This characteristically translates into confidence from shareholders.
ESG and Low Volatility Strategies: A Fitting Match
At the same time, de-risking of client portfolios in recent years has led to an increase in low volatility investments that mainly focus on financial metrics, but also go hand-in-hand with ESG metrics and reduced risk. For example, climate risk related to the continued use of fossil fuels has not only sparked public debate, but also investor skepticism about the long term-viability of industries focused or dependent on fossil fuels. As public opinion continues to evolve, these businesses might struggle to attract investors. So investing in funds void of companies that could be negatively impacted would likely reduce investment risk.
Selecting funds that encompasses ESG considerations may offer investors a buffer from a growing list of exogenous risk factors that may impair a firm’s ability to pay dividends, grow and sustain gross margins, and provide the necessary income many retirees will rely upon in the coming years. Additionally, we believe companies that consider ESG criteria are better prepared for market shifts influenced by quickly changing social and environmental norms.
Volatility has seen a 10x increase over the last decade.2 In light of this, it’s not surprising that our clients have been expressing considerable interest in low volatility strategies. Consider this: the variance drain theory makes a compelling argument in favor of avoiding highly volatile investments, since drastic ups and downs rarely result in a profit in the long-term.3 Couple this with the fact that ESG investments are strongly tied to low volatility, and it becomes clear that investors do not need to sacrifice performance in order to invest according to their values.
As many advisors are starting to realize, ESG investments, compared to non-ESG investments, may be well suited to building a long-term portfolio due to their typically lower risk profile and lower volatility. This can manifest in a multitude of ways: investors may shun companies with poor ESG ratings, thus increasing a firm’s cost of capital, limiting needed capital flows and increasing investment risk; or, conversely, investors may be drawn to firms with higher ESG ratings. In both cases, a material impact on profitability is quite noticeable.
Integrating ESG Into Client Portfolios
So, how can you help your clients incorporate ESG into their portfolios? Start with proactive engagement – it can go a long way in guiding the ESG conversation.
Pay attention to what your clients value in their investments: Companies with environmentally friendly practices? Socially responsible policies? Firms with strong governance structures to help avoid and navigate controversies? All three?
Provide a holistic, multi-asset class framework for introducing ESG. This can include building an ESG portfolio outright or simply incorporating an ESG philosophy into the investment selection and decision making process.
When you can help your clients understand the benefits of ESG – from both a values-based and investment-based perspective – you can help them build holistic, multi-asset portfolios better equipped to meet their diverse investment needs and objectives.