Investing based on ESG factors (environmental, social, governance) was expected to take a hit during the Covid-19 pandemic as the markets went into survival mode. But the opposite has happened, which we think is good news. During the 1st quarter of 2020, a period of great uncertainty and a down market, some $40 billion flowed into ESG funds, a roughly 40% increase from the 1st quarter of 2019. And during this time, ESG funds generally outperformed.
The reasons for the outperformance: (1) ESG funds typically avoid fossil-fuel investments (oil companies, etc.), which took a hit in the 1st quarter but have since rebounded along with oil prices; and (2) ESG funds tend to be overweight technology stocks, many of which continue to be beneficiaries of the homebound lifestyle caused by Covid-19. The ESG managers we use in our client portfolios also outperformed in the quarter, mainly due to an underweight to energy and focus on quality — strong businesses with lots of free cash flow.
What happens next for ESG? During the 2020s, we think ESG investing will truly come into its own and become a staple in many more portfolios. Here are three key reasons why:
#1. Ongoing focus on tech and innovation. Many articles have been written recently about the overweight that ESG funds have to technology. According to a recent report by RBC Capital Markets, these five giant growth stocks are the most common in ESG fund portfolios: Microsoft, Alphabet (Google), Visa, Apple, Cisco Systems.
For the most part, environmental ratings steer ESG managers to invest more in industries like technology, which is inherently less polluting than say utilities. The focus on tech has brought criticism in the press. Here’s the argument: Tech, healthcare, consulting and other industries do have a relatively low carbon footprint but they also have major social and governance issues: workforce diversity, contribution to economic and social inequality, privacy and surveillance issues, and tax avoidance, to name a few.
Our response to this is that no company is a perfect ESG stock. Each industry has major ESG shortcomings to deal with. This is why ESG investing involves understanding which of these shortcomings apply to a specific company or sector and using that information to make portfolio decisions — in addition to the investment fundamentals. It’s important to understand what is driving the ESG scores for any particular company and whether it is getting a high grade based only on relatively low environmental impact. That should not be the case.
That’s because, by definition, the tech sector has a limited impact on the environment relative to other industries. Perhaps the biggest environmental impacts of tech is the enormous amount of electricity required to run data centers and cloud computing operations. How that electricity is generated – fossil fuels or renewable energy – is a key issue that some of the big tech companies have started addressing in efforts to become carbon neutral in the coming decades.
At the same time, tech is likely to remain a big part of ESG portfolios, and we think that is a good thing. Tech companies are among the world’s most innovative and fastest growing, and many are able to expand through downturns. That is a big plus when you are balancing return and impact. Additionally, new technology is helping companies address climate change and other environmental issues, thereby providing ESG managers with more investment options.
#2. Stronger emphasis on corporate accountability. In January 2020, Blackrock Chairman Larry Fink wrote a letter to corporate CEOs letting them know that his company is making sustainability a key part of its investment approach. This is a major development, since Blackrock wields an enormous amount of power in the investment world, with some $7 trillion in assets under management. While Fink’s letter was motivated by the risks posed by climate change, it applies also to socioeconomic sustainability. In closing, Fink said “companies must be deliberate and committed to embracing purpose and serving all stakeholders.”
Covid-19 and racial justice protests have since then brought to the fore economic, health, and social inequalities that many companies now say they will address through new policies and actions partly because inclusiveness can help boost economic growth. ESG research and investing is a way to zero in on which companies are taking meaningful steps in this direction and which are going about business as usual. Regardless of which party wins the White House and US Senate next year, there is a movement afoot to hold corporations more accountable for their impact on society and many investors will want to be part of this movement through their portfolio choices. Finally, there is an increasing urgency to address climate change and higher unemployment through investment in new ventures, such as retrofitting buildings and low-carbon infrastructure.
#3. More nuanced and customized ESG investment options. We are convinced that ESG investing does not necessarily mean sacrificing return. By doing the due diligence required to “screen the ESG screening,” so to speak, we can come close to creating a portfolio that closely aligns with each client’s values, while providing the return they need to attain their goals. There has been an explosion in ESG funds, which is a good thing. But this also means doing more due diligence to make sure your money is doing what you think it is.
Many of the ESG managers we invest with, for example, routinely tell us of the differences between their own in-house research and that of third-party ESG ratings providers. One of the large ESG managers in our portfolios has 12 to 14 different sources for ESG data. While this asset manager may sort through a lot of third-party information, their rankings, rationale, and ultimately which stocks make it into their portfolio do not usually reflect any one ESG rating system.
ESG investing is usually not a straightforward process, but this is what allows for customization and the possibility of creating an ESG portfolio that reflects what’s important to you. Granted, it also allows for some funds to pass themselves off as ESG when in fact they are not. And vice versa. And this is why we put such a big emphasis on vetting ESG managers for our portfolios.