Why Impact Investing's Time Has Come

[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].”

Fixed-Income Opportunities
Socially responsible investing has seen more growth on the equity side than in fixed income. William Sokol, product manager at VanEck, which issues the VanEck Vectors Green Bond ETF (GRNB), says ESG is just starting to take off in debt markets.

Although bondholders can’t vote proxies the way equity shareholders can, there’s been greater engagement between bond issuers and investors about issuers’ sustainability credentials. That’s new to the fixed-income world, he notes.

ESG data metrics are sorely lacking for fixed income, but third-party raters like MSCI or Sustainalytics are starting to look at the broader activities of the bond issuer. But Sokol notes these assessments are still subjective.

It’s one reason green bonds are gaining traction, he says, because the bond focuses on the project, not necessarily the issuer’s credentials, which may or may not follow ESG principles.

“You just look at what the bond is financing, and that’s all fully disclosed before the bond is issued,” Sokol says.

Finding Consensus
Finkelman says more consensus about best practices and strategies is critical for further ESG adoption. Some progress is being made, and one group helping to bring consensus to the industry is the Sustainability Accounting Standards Board, which develops and disseminates sustainability accounting standards. With more evidence showing that socially responsible strategies can deliver enhanced returns, the next step is deciding the right way to implement ESG analysis.

“There’s still more work to be done on reaching consensus across the market about what it is with ESG that can help drive returns, and what approaches really do best,” he said.

There are still a number of socially responsible ETFs with low AUM because of this lack of consensus on why ESG works, Finkelman says. But as more data is collected and the data time series grows, why ESG factors perform may become clearer.

That could mean some socially responsible investing ETFs close, but Finkelman says that could be good, since “the product will be more robust going forward and more stable perhaps.”

As ESG evolves, Tim Clift, chief investment strategist at Envestnet | PMC, says he’d like to see ESG reporting advance to a level where investors can compare how their portfolios stack up against broader indexes.

“I’d love to see what my carbon footprint is compared to the broad index …,” he said, “that my carbon footprint in this portfolio is 50% less or 80% less than the benchmark.”

That may take more data than is currently available, but Clift says that could have a powerful effect on investors: “That’s much more impactful when you open up your statement. Not only did I do something good at the beginning, but it’s actually doing what [the ETF issuer] said they’re going to do.