Why Impact Investing's Time Has Come

February 25, 2019

[This article appears in our March 2019 issue of ETF Report.]

Environmental, socially responsible and governmental (ESG) investing has evolved over the years, from simply screening out companies based on religious, moral or ethical grounds, to including companies as a way to reward good behavior, or encourage them to change business practices.

ESG lets investors better pinpoint favored causes, such as addressing climate change or advocating for more women on corporate boards. Responsible investing’s latest evolution focuses on impact, which seeks even more targeted ways to support a cause.

The latest spate of ETFs focusing on cause-based themes includes the Impact Shares YWCA Women’s Empowerment ETF (WOMN), the Impact Shares NAACP Minority Empowerment ETF (NACP) and the Goldman Sachs JUST U.S. Large Cap Equity ETF (JUST).

Dueling Trends
Two phenomena coincided to promote ESG evolution: more data and client demand. Stronger computer power and improvements in technology such as artificial intelligence have led to greater data available and more ESG niche data providers, says Hendrik Bartel, co-founder and chief executive officer of data provider Truvalue Labs, allowing index providers to offer differentiated products.

As investors incorporate socially responsible investing into their portfolios, their motivations sometimes change, says Jeff Finkelman, a senior research associate in impact investments at Athena Capital Advisors, an advisory firm that focuses on socially responsible investing.

What’s also changed are attitudes about performance. Investors are no longer concerned about socially responsible strategies’ potential underperformance. Now there’s growing evidence that ESG factors can outperform and reduce volatility, Finkelman says, especially since companies preferred by ESG investors often are high-quality companies with long-term outlooks.

A February 2018 study by the United Nations Principles for Responsible Investment (UNPRI) used MSCI ESG Research analytics and data to evaluate cumulative returns from ESG portfolios. UNPRI tracked the difference in a company’s ESG score at the time and in the prior year, which they call momentum, and also measured point-in-time ESG scores, which they call tilt.

In a world stock portfolio, the ESG momentum and tilt strategies outperformed the MSCI World Index by 16.8% and 11.2% in active cumulative returns, respectively, over a 10-year period. For U.S. equities, the ESG momentum strategy outperformed the MSCI US Index by 18.8%, while the ESG tilt strategy underperformed the benchmark by 1.6% in active cumulative returns over a 10-year period.

Companies Also Adapting
Jon Hale, global head of sustainability research at Morningstar, says the ESG growth isn’t just investor-centric, that companies are changing their behavior and realizing there’s a financial component to sustainability. Whether sustainability challenges are related to climate change, how they attract and retain talent, oversee their supply chain or protect data, it’s much easier to collect information on corporate behavior and easier to disseminate.

“It’s much more at the top of mind for companies today to understand that there’s kind of a shift in thinking, [realizing] that ‘I’m going to need to address these kinds of issues or it’s going to hurt us; it’s going to hurt us with our customers,’” Hale said.

Institutional investors are considering climate-related risks from a financial perspective, not a values-driven view, another reason behind ESG’s evolution, Hale adds.

“Institutional investors who have a fiduciary perspective to maintain first and foremost in their investing are now saying we have to consider ESG-related issues in our investment process,” he noted.

Growth Obstacles
Demand for ESG ETF products is growing, as the amount of money earmarked to socially responsible ETFs rose 63% over a year ago to $7.9 billion in assets under management (AUM). But perspective is important. ESG investing is a fraction of the $3.5 trillion invested in the ETF industry. Part of the across-the-board adoption slowness may be a lack of understanding—still—of how socially responsible investments work in a portfolio.

John Goldstein, managing director, ESG and impact investing at Goldman Sachs, says some of the challenges they found when looking at ESG offerings were that some were too narrowly focused, while the broader-based ETFs were based on difficult-to-explain ESG scores that solely reviewed company policies, rather than looking at actual performance on meaningful issues.

When constructing the JUST ETF, Goldstein says they wanted to focus on “a real story to tell.” JUST selects U.S.-listed large-cap stocks using a survey-based assessment of business behavior and looks at performance.

“The polling shows a set of things that make a lot of sense to people,” Goldstein said. “You don’t have to get savvy on a whole new methodology to understand that treating your workers well and your customers well, having a good product, being good to the environment, being good to communities [is what works].”

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