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1. What ESG entails

2. Evolution of ESG Investing

3. IQ’s View: Why we believe it’s a mega-trend that will continue

4. Conclusion

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1. What does ESG entail?

What ESG stand for

ESG or “Environmental, Social, and Corporate Governance” refers to sustainability and societal related aspects of a company’s business (see diagram below). When these aspects are actively considered by investors when deciding whether to invest in a company, then that’s ESG Investing.

Motivations for ESG Investing

There are three main motivations for ESG Investing: Ethical Conscience, Societal Impact, and Financial Returns (see diagram below). 

The first two are self-explanatory, but Financial Returns may not be the most intuitive motivation so we’ll elaborate on that. In short, there are two reasons why ESG stocks may outperform the market. 

First and most obviously, ESG stocks may outperform in the shorter-term due to significant fund inflows into the space. The chart below shows the outperformance of US Renewables vs S&P 500 over the past year, and it was spurred by fund inflows into the ESG space. It is important to note that fund inflows and outflows are hard to predict, but as we will explore in Section 4, the interest in ESG Investing rides on the back of some very real changes: expectations of massive green capex (which should help future earnings), institutional adoption, technological advancements, and ongoing pressures from socio-economic and environmental challenges.

Second, ESG stocks may outperform in the long-term because companies possessing certain positive ESG attributes may be more likely to deliver positive outcomes for shareholders. For instance, Goldman Sach’s portfolio strategy team found that companies that employed a higher % of women were associated with stock market outperformance (first chart below), and the outperformance was especially stark for companies with more female representation on the Board of Directors (second chart below). 

ESG Investing has grown in significance…

ESG investing has grown in significance over the past decade, especially in North America and Western Europe. From the chart below, we can see that the no. of ESG funds worldwide has increased ~84% from 2012 to 2020. Whilst not obvious from this particular chart, 2020 saw a massive influx of AUM into ESG funds (both active and passive vehicles). 

In particular, since the start of 2020, ESG-focused funds saw sizeable AUM inflows which is made extra significant because of the large AUM outflow from all other equity funds (see below). 

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2. Evolution of ESG Investing

Values-Based Investing

ESG investing began in the 1960s, initially taking the form of “values-based investing” in which investors sought to align their portfolios with their beliefs/norms. This came in the form of avoidance of certain industries based on the business activities, e.g. tobacco production or involvement in the South African apartheid regime.

Impact Investing

As new technologies were developed, ESG investing evolved to include a focus on “impact investing”, in which investors sought to drive social or environmental change by using their capital. For instance, by providing private and public market funding for clean tech and fintech, or by indicating greater demand for green bonds.  

ESG ratings: Evolution to accommodate a greater focus on investment returns

In more recent years, there has been an effort to standardize the assessment of companies across industries through ESG ratings. Unlike “values-based” or “impact” screens which typically rely on a judgment of the business activity, ESG ratings focus on a broad range of indicators (carbon footprint, water usage, data security, human-capital development, executive pay and board structure, etc.). 

Several of these ESG ratings are preference-based, meaning they are constructed on a normative scale, based on standards set by rater. 

However, increasingly, more attention has been paid to ESG ratings based on financial models, i.e. those that select and weight ESG indicators based on an economic rationale (i.e. whether a company’s performance with regard to a certain ESG indicator impacts its earnings or asset values). 

We believe ESG frameworks will continue to evolve to accommodate the growing emphasis on investment returns. As it stands, return-hungry investors already have reason to pay attention to ESG stocks: according to MSCI, high ESG-rated companies were more profitable, paid higher dividends, showed higher valuation levels, and had a lower frequency of stock-specific risks.

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3. IQ’s View: Why we believe it’s a mega-trend that will continue

Reason 1: Whole eco-system moving in the same direction

Different parties within the financial eco-system are pushing for or adapting to the changes brought about by the increased focus in ESG. Below, we go through some of the most significant developments happening with segments      of the eco-system.

The Public

First, public sentiment. There are several indicators of ground-up support in terms of sentiment especially with regard to environmental and social concerns, especially in the West. Beyond the #metoo and #blacklivesmatter campaigns that have spurred protests in the United States and elsewhere, there also has been increasing dialogue online on sustainability issues. Among other things, concern for the environment has been spurred by high profile features of student activist Greta Thunberg as well as the debate over Trump’s environmental policies. 

Take a look at the chart below for the performance of “ESG” as a search term on Google Trends. 

Institutional Investors

Second, institutional investors. With regard to institutional investors, there has been a growth in divestment pledges, as well as a steadily growing range of ESG investment products offered to end-clients. 

In particular, the United Nation’s Principles for Responsible Investment (PRI) is an international network of investors working to promote sustainable investing. It is one of the most important ESG initiatives. PRI signatories are currently required to incorporate ESG considerations into at least 50% of their AUM, a sum of around US$100 trillion. 

Many fund management companies are also signatories of the UN PRI. Schroders, for example, has consistently received the highest rating (A+) on its ESG strategy and has various ESG funds that implement ESG strategies holistically, such as the Schroder Global Sustainable Growth Fund.   

The greater involvement of sophisticated institutional investors in the ESG space will push fund managers to manufacture better and more ESG fund products, and this will in turn improve the availability of ESG funds to retail investors.

Publicly Listed Firms

Third, publicly listed firms. On the back of public pressure, there are a growing number of listed companies pledging changes with regard to gender equality, racial diversity, sustainability. There have also been a growing number of climate-related shareholder proposals (see below). 

This will help fund managers and research companies better assess how different companies rank in terms of ESG matrices.

Regulators & Data Providers

Fourth, regulators and data providers. Several regulatory bodies have announced regulations/guidelines on sustainability-related disclosures by financial market participants (see below). In addition, there are also initiatives to harmonize ESG standards across the various market participants (see second chart below).

Governments

Fifth, governments. Government initiatives are particularly important for ESG companies since they can translate into stricter environmental regulations as well as massive federal spending/capex. 

In the United States, the Biden administration has shown a particular focus on climate-related issues. As quoted from his campaign website, Biden’s climate plans include:

• Making a federal investment of US$1.7 trillion over the next ten years, leveraging additional private sector and state and local investments to total to more than US$5 trillion. For context, US$5 trillion is roughly equivalent to the annual GDP of Russia, Brazil, Mexico and Australia…combined.
• Ensuring the US achieves a 100% clean energy economy and reaches net-zero emissions no later than 2050.

Biden’s administration has started work on some of his climate objectives. On his first day, he has already signed an executive order recommitting the US to the Paris Agreement. He has also urged China to toughen one of its targets on greenhouse gas emissions. As shown in the chart below from Goldman Sachs research team, the EU, China, and Biden administration have recently announced ambitious emissions targets. 

In Singapore, we have similarly ambitious plans to address climate change. For instance, here are some new initiatives under the Singapore Green Plan 2030 that were just announced earlier this month: 

• Quadruple solar energy deployment to 1.5 gigawatt-peak by 2025
• All new car and taxi registrations are to be cleaner-energy models from 2030
• A targeted 60k electric vehicle charging points to be added by 2030 
• 80% of new buildings to be super-low-energy from 2030
• Over 1,000 hectares of green space is to be added by 2035

In tandem with these initiatives, the Singapore government announced that it will issue green bonds for S$19b worth of infrastructure projects. In comparison, ASEAN’s total green bond issuances from 2016 to 2019 came up to only S$10.8b.  

With these top-down directives supporting Singapore’s development into a hub for green finance, we believe that private corporations will soon follow suit and offer a greater range of products to satiate local investor demand. Click here to read more on ESG investing in the Singaporean context.  

Reason 2: Social & Environmental Pressures to Continue

In our opinion, major social and environmental pressures will continue to be at  the forefront of public discourse for at least the next few years, especially in the West. As mentioned previously, anti-sexual harassment and anti-racism campaigns have gained traction in the United States as well as other western nations. On the environmental side, the World Economic Forum highlights mass methane release as one of the most concerning tipping points. 

In addition, existing socio-economic problems have been significantly exacerbated by the Covid-19 crisis. The UN International Labour Organization estimated that Covid-19 cost the world the equivalent of 255m jobs in 2020, nearly four times the number lost during the 2009 global financial crisis. Based on World Bank predictions, the global population living below the extreme poverty line increased by 88m people in 2020. 

Even with the vaccine, there are issues with the uneven distribution of supply which may further worsen economic disparities between countries. Below, we show a chart of the unequal vaccine supply across countries.

The pandemic has clearly brought issues of employee management, safety and welfare to the forefront. For instance, data compiled by Goldman Sachs shows that there has been rising mentions of “Covid-19” and “employee” in corporate transcripts in the US. The Goldman Sachs research team found a similar trend for the EU when they looked at STOXX Europe 600 companies. 

As these socio-economic and environmental pressures continue to be a looming concern for the public and for companies, we believe ESG Investing will be a natural extension of the individual’s as well as the institutional response to these challenges.

Reason 3: Overlap with technological and corporate innovation

Several companies fall into the ESG investing bucket because they provide more sustainable alternatives compared to traditional players. For instance, green technology, driverless cars, mobile payment, waste reduction are all popular ESG investing verticals. It goes without saying that a majority of these companies rely on technological innovations as the backbone of their products and services. 

Yet, even as we disregard ESG for a moment, several technological advancements show a coincidental overlap with ESG objectives. For instance, even before Covid-19, increasingly powerful remote control and automation solutions were making international travel more redundant, and mobile solutions were making both individuals and institutions less reliant on paper-based recording. Even at the cutting edge, Artificial Intelligence (AI) systems are being used by a variety of industries to eliminate inefficiencies that may also result in a better use of natural resources. 

Meanwhile, corporate innovation has meant a worldwide shift towards platform-type business models (e.g. Airbnb vs hotels, or Uber vs taxis). These platform-type innovations coincidentally have ESG-friendly features, as they often involve a higher utilization of existing resources (through reducing the need for more infrastructure) and by extension, involve less wastage. 

There is significant overlap in the direction of current technological advancements and the innovations driven by ESG concerns. While it remains to be seen whether the overwhelming outperformance of ESG stocks in 2020 can be replicated in subsequent years, we do believe that the growth in ESG Investing is the result of very real changes (massive green capex, institutional adoption, technological advancements, socio-economic and environmental challenges) that may only snowball from here on out. ESG Investing is much more than a fad, and is worth more than a passing consideration.  

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4. Conclusion

As investors, we are excited to witness the development of what could be a multi-decade investment theme. Many investors used to view ESG investing synonymously with charity, a social venture that comes at the expense of financial returns. Increasingly, we see evidence that this is not true, and investing in socially responsible companies do lead to better investment outcomes. 

It is challenging for individual investors to choose between the different ESG investment options available in the market, given the different ESG matrices, ratings, and investment approaches there are available. The value of fund manager and fund due diligence by a trusted advisor to recommend and monitor funds is more important in ESG investing than usual passive or even thematic investing.

Endowus has just launched the industry’s first multi manager, multi asset portfolio that allows you to invest sustainably while keeping to your own risk tolerance. The Endowus ESG portfolio is independently constructed by the Investment office using award winning ESG, sustainable and climate equity funds (such as the Mirova Global Equities Fund) and fixed income funds (PIMCO Climate Bond Fund)  based on your risk profiles. These are run by award-winning managers who are pioneers and leaders in the field of ESG investing, with decades of experience and industry-leading, processes in managing ESG funds.

If you’d like to start an ESG portfolio with Endowus, you’ll be delighted to know that The InvestQuest readers can have $20 managed for free in fees. Sign up using this link to claim this special offer.