[This article appears in our March 2019 issue of ETF Report.]
There’s growing evidence suggesting investors who incorporate environmental, socially responsible and governance (ESG) metrics may outperform traditional indices.
But what do investors get out of ESG approaches besides saying they do well by doing good? Turns out there’s more to ESG investing than simply performance.
ESG market watchers and participants say there are interlacing benefits people get from this investing theme. There are financial benefits, as ESG investors look at both what companies make and how they are run, often choosing high-quality firms. Benefits can be emotional and values-driven, as people choose their investments to align with other life choices.
And it can encourage investors to take a more hands-on approach to their portfolio, to really understand their holdings, rather than blindly letting a fund manager or an advisor do the work. That attachment can keep people invested during all market cycles, improving outcome odds.
Honing In On Return Drivers
Jon Hale, global head of sustainability research at Morningstar, says that because there are so many ways to apply ESG factors, it can be hard to pinpoint exactly what drives financial results, but many indices are constructed with higher-quality companies that often have lower volatility, which can be positive investing characteristics.
Then there is the behavioral side to this investing style. “Average investors, individual investors get other benefits out of [ESG] investing,” he said. “Investing is not purely utilitarian; it’s not purely about just what your bottom line is.”
Hale says that in the initial era of popular investing—the mutual-fund era of the 1990s until the 2008 financial crisis—individual investors were instructed to listen to financial market experts about how to invest, and to not bring their own values in; otherwise, that would skew performance. But he says that advice is misguided, as it ignores the way people make other financial decisions.
He used another example of how investment decisions aren’t always bottom-line driven: “There are a lot of people out there who are bargain shoppers when they spend money. They love to … buy low-fee investments. It’s not purely for this narrow reason they think they're always going to outperform; it's because they feel like they're getting a bargain for it, and that makes them feel good.”
Sarah Kjellberg, head of BlackRock's iShares Sustainable ETFs, says portfolio construction principles “do not go out the window,” when it comes to ESG investing. Rather, entire portfolios can be built in a way that aligns with an investor’s overall motivation, and there’s no a one-size-fits-all approach.
Whole Portfolios, Not Niches
ESG is still sometimes perceived as a sleeve in a total asset allocation, made up of niche satellite holdings, focusing on, say, clean water or renewable energy, rather than constructing core holdings and adding satellite investments. But as ESG has evolved, ETF issuers are building complete ESG portfolio offerings, making it much easier for investors to build diversified portfolios, Kjellberg says. But education is still needed.
“We have these asset allocation building blocks ... and various satellite exposures like low carbon or impact investing,: she said. “We have these choices and it's really incumbent upon the asset management community to help investors think these through.”
Kjellberg also says that investors interested in ESG don’t want to just dip a toe in the socially responsible investing pool, they want to dive right in completely.
“From our experience—and particularly working with financial advisors—what we’ve found is that their clients are seeking ‘full activation’; they want 100%,” she noted, adding that BlackRock works with financial advisors to create transition-type portfolios to avoid tax consequences of switching products from traditional investing to ESG.