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Public companies have long had a single, overriding objective: maximize shareholder value. Traditionally, investors have sought out firms that are laser focused on this goal and seldom asked very many questions about how they deliver the goods.
But with climate change disrupting global ecosystems, and debates surrounding social and economic justice moving to the fore, new generations of investors are taking a more holistic view of how they put their money to work. Many are adopting ESG strategies to help them look beyond solely monetary returns.
What Is ESG Investing?
ESG is more than just the latest Wall Street acronym. It aims to drive positive change in society by evaluating how companies operate in three key areas: environment, social and governance, or ESG. The goal is to channel capital to companies that work to meet or exceed commonly established standards in each of these three realms—and keep money away from firms that don’t.
When it comes to the environment, ESG calls on companies to reduce their own environmental impact and help address broader challenges such as climate change. Firms that rank high on the social component encourage diversity and inclusion among executives and staff alike and are fair and equitable in hiring practices and compensation. They also consider how their businesses impact their community and contribute to the greater social good.
Governance relates to the behavior of the board and management and the practices and controls a company implements to govern itself, make decisions, ensure regulatory compliance and meet the needs of external stakeholders. It includes everything from how the board and management interact with shareholders to how they manage the business, compensate executives and promote diversity in leadership.
Typically, third-party, independent research groups rate corporate performance according to environmental and social responsibility scales, and ESG investors use these ratings to direct their investing dollars.
Global Investment Managers Are Leading the Charge
Take Larry Fink, CEO of BlackRock, the world’s largest investment manager. In his 2020 and 2021 annual letters to CEOs, Fink emphasized corporate and environmental responsibility and noted that beyond just shareholder value, corporate behavior will drive his firm’s investment decision-making. For additional emphasis, BlackRock’s 2020 Investment Stewardship Report stated that ESG principles are “core to long-term value creation” for clients.
Outside of institutions, ESG investing has gained significant traction among high-net-worth individuals (HNWIs). According to the World Wealth Report 2020, a survey conducted by global consulting powerhouse Capgemini, more than a quarter (27 percent) of HNWI investors are directing capital into ESG sustainable investing products. The percentage rises among ultra-high-net-worth individuals (UHNWIs)—those with $30 million or more in investable assets—with 40 percent pursuing ESG sustainable investment strategies. Investors under 40 are even more serious about sustainable investing, with 49 percent of UHNWI investors in this age group reporting a commitment to including ESG strategies in their portfolios.
ESG Is About Better Returns—Not Virtue Signaling
In theory, we all want to make ethical choices, but many investors have hesitated when it comes to ESG investing, fearing that investing “on principle” will come at the price of reduced investment returns. That certainly wasn’t the case in 2020, which was a very good year for the best ESG funds. Three out of four sustainable equity funds outperformed their Morningstar averages while the majority of ESG equity index funds beat conventional index funds, even when accounting for their comparatively higher operating costs.
What’s more, evidence suggests that companies with sustainable business practices demonstrate increased profitability and higher valuations. A 2020 study from ISS Governance found that a link does indeed exist between a company’s ESG performance and its financial performance.
This bears out even during times of crisis, like during the Covid-19 pandemic. Analysis by Morningstar found that during the initial phase of the pandemic, when the stock market declined precipitously, ESG equity funds booked less severe losses than their conventional peers. This is in line with the belief many experts hold that companies with high ESG ratings are more resilient, with the stocks better able to weather a bear market.
ESG Isn’t a Trend—It’s About Seizing Opportunities
Some say that ESG investing is just a fad, but the factors driving demand among investors for sustainable business practices are not going away. We face growing challenges, particularly climate change, that have deep ramifications for the global economy and our way of life.
ESG practitioners argue that these obstacles offer rich opportunities for savvy investors. The move away from fossil fuels to renewable sources of energy is an area rich in promise, for instance—and many argue these changes are inevitable, making it imperative for companies to begin the transition to clean energy sooner rather than later.
Leaving aside ethical considerations, sustainability makes for good business. Companies that put ESG principles front and center benefit from increased profitability and higher valuations. ESG practices can increase productivity, heighten employee satisfaction and enhance reputation and brand—benefits that translate into growth in revenue.
Many investors are embracing ESG as a moral imperative. However, whether an investor’s motivation is rooted in a pragmatic desire to maximize returns or idealism, ESG investing presents opportunities too compelling to overlook.
Rebecca Baldridge, CFA, is an investment professional and financial writer with over 20 years of experience in the financial services industry. She is a founding partner in Quartet Communications, a financial communications and content creation firm.