For many outside the industry, the lexicon used by the world’s financial leaders and firms can often seem built more on buzzwords than meaning, with terms rising and falling out of fashion as the industry adapts to changing consumer preferences and a rapidly growing global financial sector. Of such words, Environmental, Social, and Corporate Governance, oft shortened to ESG, has gained significant prominence. However, far from being a buzzword, ESG symbolizes a critical shift in today’s investment and business world towards sustainable business models that reflects the power that finance ultimately has and the role it serves in society.
ESG today refers to an investment framework that looks beyond financial metrics and evaluates the long-term impact that a business model can have on society, taking into account factors that extend far beyond climate change and touch on human rights, health and safety, and accountability (1). It is a values-driven framework which posits that businesses that focus on these factors will ultimately be more in touch with consumers, more sustainable, and provide a more appealing product.
Such a shift in investing framework is of course largely due to a world where increasing interconnectedness and mobile phone penetration has given people the ability to monitor and hold businesses accountable to their mission. This is further fueled by the availability and harnessing of big data, which allows us to quantify and track metrics previously impossible (4). One manifestation of this change gained traction on Instagram and other social media platforms with the “Save Ralph” mockumentary, where users have been pointing out and demanding change from laws and companies that test cosmetic products on animals (2). More and more businesses have started included an ESG focus in their annual reports or even publishing separate reports to reflect the rising demand for this kind of information from investors (3).
ESG builds on Socially Responsible Investing (SRI), which gained popularity in the 70s. Whereas SRI used screening to block out investments in industries traditionally considered “immoral,” such as tobacco, gambling, and weapons, modern ESG techniques focus on inclusivity (1)(3). Rather than screening out certain companies, ESG-focused fund managers will determine investments they find attractive based on traditional financial metrics, then carefully select the ones that show the most promise for social impact (1)(5).
While excellent social returns and excellent financial returns have been traditionally viewed as mutually exclusive, the data shows that is absolutely not the case. As Elena Philipova, Global Head of ESG at Refinitiv, points out, “ESG companies and portfolios have been simply more resilient, and that’s true for indices, where ESG indices perform better than benchmarks… it’s also true for ESG funds… which outperform the peer funds on relevant technical indicators. Good ESG companies outperform the market, and also they have smaller earnings per share cuts” (5). Indeed, there is a strong logical explanation for this. ESG focused companies are likelier to be in touch with modern consumers and reflect their more socially aware preferences, and they are also likelier by nature to have a stronger mission, identity, and long-term sustainable game plan. The result of investors and professionals realizing and accepting ESG’s potential has been tremendous. According to Deloitte, ESG-mandated assets could grow to become half of all professionally managed investments in the United States by 2025 (6).
Indeed, asset and wealth managers, as stewards of the world’s capital, thus have a significant task before them: to make their clients aware of the benefits, both financial and social, of an ESG-driven portfolio. 68% of investment managers believe that product customization will thus fuel growth, and “an estimated 200 new funds in the United States with an ESG investment mandate are expected to launch over the next three years, more than doubling the activity from the previous three years” (6).
While people are more knowledgeable than ever before about whether and how businesses are adhering to their ESG proposals, many don’t realize how important it is for investors on an individual level to implement it into their own portfolios. Partner and head of sustainable investing at LGT Vestra Phoebe Stone commented that “most investors aren’t aware that it is possible to express these views through their portfolio and allocate capital to companies focused on long-term sustainability” (7). Thus, it largely rests on the shoulders of financial professionals to bring forward ESG-driven portfolios and convince clients of their merits. Asset and wealth managers should take it upon themselves to bring up ESG in conversations with clients, not forcing them to adopt such portfolios but at the very least setting before them ESG products and highlighting the robustness of ESG-driven businesses.
Across the Atlantic, Europe is taking an even more aggressive approach towards ESG. New ESG regulation is making it easier to identify and reward ESG-driven companies by implementing a more standardized taxonomy and requiring companies to consider and disclose how ESG factors may affect investment decisions via the Sustainable Finance Disclosure Regulation (SFDR) (9). The SFDR also requires “financial market participants” to inform their clients about how ESG factors affect the services they provide. They are also required to disclose how they take ESG into account when proposing investment opportunities to clients, as well as include in their website an explanation of their due diligence process in understanding risk factors within the ESG framework (10). Thus, the European Union isn’t just nudging portfolio managers towards ESG implementation, it is requiring it.
Clients will naturally begin gravitating towards these portfolios as they see that companies who incorporate ESG-conscious decision-making frameworks into their operations are better equipped for the future. Indeed, such a shift is already in full swing. Kara Mangone, COO of the Sustainable Finance Group at Goldman Sachs remarked that “over the past 12 to 18 months, the dialogue from our clients has really accelerated… It’s not just the volume of requests and interest we are getting — it’s also the depth and complexity of the challenges our clients are trying to solve” (8). Asset and wealth manages can therefore both create and meet demand in the ESG space.
We are heading towards a world in which ESG-mandated investing will likely be the norm. As Elena Philipova adds, “capital allocation decisions must align with the future that we all want to finance” (5). As the financial sector’s job is to responsibly allocate the world’s capital, it must bring its tremendous firepower to bear on the value-driven in investment framework, not only in the pursuit of financial returns but in that of a better, healthier world as well.