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Playing The Long Game

Establishing long-term environmental, social, and governance (ESG) investment objectives, and taking an active approach to integrating them, is essential to enable the transformation that the financial and business industries need to achieve to establish a sustainable future for all. This is because if we have the ability to leverage capital markets, we have the resources that we need to solve some of the most pressing and intractable global issues. According to the United Nations Sustainable Development Goals, solving these issues comes with an annual price tag of $5-7 trillion: with every passing month and year, that price tag increases.

Our future literally depends on the commitment, methods, and urgency with which we act − and this absolutely, critically includes global companies and investment managers.

But recently, ESG investing has been facing mounting headwinds. And while it may sound like a “nice to have” for some, or a lofty idea that firms simply tout for marketing purposes without action − the bedrock of greenwashing − the reality is that the data doesn’t lie. This is critical to the survival of people and our planet. And when done right, it can generate a strong profit in the process.

Today, a large number of investors establish sustainability or ESG objectives as part of their global strategies. According to Capital Group’s ESG Global Study 2022, nearly two-thirds (63 per cent) of investors globally prefer to use active funds to integrate ESG principles into their portfolios, with equities (80 per cent) over bonds (58 per cent) being the most popular asset classes to gain ESG exposure. This varies by region. The study also found that more Europeans consider ESG to be ‘central’ to their investment approach (31 per cent, versus 26 per cent globally), while investors in North America have the least conviction in ESG, with less than one in five reporting that ESG is central to their investment approach (18 per cent), behind those in the Asia-Pacific region (22 per cent). However, in many cases, a large percentage of these ESG objectives are not well-defined or measurable − perhaps one of the biggest hurdles facing the investment strategy, due to the lack of consistent standards and definitions − thereby minimising the ability to generate true transformation. This issue has been steadily improving, but it still has a long way to go.

Therefore, it’s critical that when establishing ESG objectives, investment managers and companies must take a long-term approach. Not only do short-term objectives encourage a short-term thinking process − which inevitably prevents growth and real change − but long-term objectives allow for innovative solutions. These objectives must also be ambitious and linked to specific benchmarks for improvements, with specific dates earmarked to enable their achievement.

While traditional ESG objectives were set to reduce the negative impact of companies’ activities through exclusionary or ‘screening out’ tactics, only the objectives that seek to make changes to their entire value chain, as well as to society − those which take an active, positive stance bordering on impact investing − will lead to transformation. It’s critical to recognise that these objectives create a gradual and mounting impact, and seek to achieve real internal progression at all levels. It takes time.

What many investors fail to recognise is that long-term ESG objectives help investment managers and companies improve risk management, increase business profitability, renew and enhance their brand image, and ensure that their social and financial objectives are met. And while it’s often downplayed − perhaps because its importance is misunderstood − good governance is a key driver of the transition process from the beginning. This means having decision-makers that oversee the creation of new policies and internal procedures which establish strategic action plans that will ultimately benefit people and the planet, alongside the creation of profit. Without a doubt, long-term ESG objectives must be measurable to gradually monitor their achievement, so that companies can publish the level of compliance of their commitments in an accurate and transparent way.

In summary: The need for proactive and positive ESG investments is urgent. But the investments must be allowed the benefit of time to create real transformation.

In light of the above, why are ESG investors seeing their portfolio shrink after two blockbuster years of investment?

As of May of this year, ESG-focused equity funds saw the largest monthly outflow in over three years. In fact, it was literally the only monthly net outflow during that period. To boot, after over three years of net inflows, investors pulled cash out of US equity exchange-traded funds (ETFs) with higher ESG standards to the tune of $2 billion − the biggest monthly cash pullback in history. Why the mass exodus, particularly at a time when ESG standards are arguably more important than ever before?

Playing The Long Game

 

It’s true. Never before in our lifetime has systemic change been more relevant and vital. As we enter a new era where global pandemics, climate change, the global water crisis, systemic racism, and gender and income inequality continue to hinder our progress and the sustainability of our planet, we have an urgent responsibility to rebuild our systems and walk the talk. ESG investment − particularly that which goes beyond simple exclusionary tactics (i.e., divesting from fossil fuels, weapons, tobacco, and other negative or harmful elements), and actually takes a more engaged and proactive approach (i.e., making positive social investments that can create real change) − is a key part of this. So, we ask the question again: Why now? What’s behind the great ESG recession of 2022?

Well, it’s a nuanced issue with more than one explanation. And it’s important to note that this isn’t the case across the board. Despite the plummet in socially responsible stocks, fixed income hasn’t necessarily shared the same story.

About $75 million poured into fixed income ESG ETFs in the same month that capital poured out of its equity counterpart, although the flows were fairly concentrated in a handful of bond funds. While a portion of those purchases could be attributed to a broader shift away from equities, they’re also potentially the result of ‘out of sight, out of mind’ investing, as buyers tend to view fixed income as ‘safer’ in general, and simply park cash rather than trade it. In other words, there isn’t much of a correlation to what’s happening here.

In our view at Lebec Consulting, a large part of the outflows likely result from the common misconception that ESG and other social impact funds cannot achieve positive financial returns that more traditional funds may achieve − and that misconception seems to be asset class agnostic. Investors across equity, fixed income, and alternatives like private equity and real estate all seem to be misinformed in this vein. In fact, only 13 per cent of investors today believe that ESG investments will deliver better returns than non-ESG investments.

On the contrary, these funds have the ability to fare quite well. In the first year of the pandemic, large funds with ESG criteria outperformed the broader market, according to an analysis of 26 ESG ETFs and mutual funds with more than $250 million in assets under management (AUM) by S&P Global. It was one of many such analyses that suggested ESG risks matter for investment performance. But with such widespread misconceptions about this − particularly at a time when people are divesting across the board − it’s no surprise that these funds are among the first to suffer.

Now, we’d be remiss if we didn’t state that not all ESG funds are created equal. Some do underperform other financial vehicles, with investors choosing social impact over financial performance for at least a portion of their overall portfolio. But the best ESG funds out there can absolutely achieve both. Case in point: Goldman Sachs published an analysis in January of this year, which looked at 1,202 global companies, and found that those with strong ESG ratings (4-star rankings and above) returned 9 per cent on average, while those with lower than 4-star rankings returned only 2 per cent on average. Metrics and key performance indicators (KPIs) matter. Due diligence matters. Expertise in the social impact area matters. And the bottom line is this: If investors do their work, they can achieve a strong profit while also generating measurable social impact.

But perhaps the simplest explanation for the massive ESG investment outflows could be the current stage of the economic cycle. We’re finally coming off the heels of a global pandemic that touched and devastated nearly every corner of business and humanity across the globe. This isn’t to say the economy is booming now; all signs show we’re heading into a (long overdue) recession. If you have any questions about that, look no further than mortgage rates, or your grocery and gas bills. Inflation is the name of the game. Historically, across every inflationary environment, people do the exact thing that they should never do: they withdraw investment funds, take a major loss, and hoard cash, rather than holding their funds until they recover and grow. This pattern certainly includes ESG funds. The irony is that ESG funds, by nature, are meant to be held longer-term − the largest, most intractable global issues are not solved overnight. So, make no mistake: divestment from these funds on such a scale will have a devastating effect on our world and the progress that we make on behalf of people and the planet.

Why should ESG investing be considered a long-term strategy that will occasionally face headwinds? Why should ESG investors be patient, and how is ESG designed to solve long-term challenges?

All investment strategies face headwinds from time to time, and ESG investing is no exception. Much of the current resistance stems from the fact that ESG is a growing field and there is still a lot of work to do. For example, we need a global baseline for high quality ESG and sustainability reporting. The development of the International Sustainability Standards Board (ISSB) − recently launched by the International Financial Reporting Standards (IFRS) Foundation, to develop a comprehensive global baseline of sustainability disclosure standard − is helping with this. However, we still lack a common approach and comparable, reliable data across the E, the S, and the G. Hence, self-reporting − alongside multiple and constantly-changing regulatory requirements for disclosures, reporting, and marketing − can become costly and create headwinds for ESG investing. Digging in now and ensuring that all investments are assessed through an ESG lens will help investors be better prepared and successful in the future.

Another reason for the headwinds is the fact that ESG investing, again, is designed to solve long-term, intractable challenges: literally, the opposite of immediate returns on investment (ROIs) at the cost of everything else. But integrating ESG factors provides us with an opportunity to invest in our future, while generating both social and financial returns. It’s a chance to prioritise people and the planet − alongside profit − and invest in and/or buy from companies with more diverse leaders and decision- makers. It literally means creating a global economy that lives within its environmental means, reduces inequalities, and steers money and power away from countries and companies that violate human rights. In short, it’s a way forward that will help us prevent a climate catastrophe and the next big scandal. And – ironically − position us for greater economic, and therefore financial, success.

Playing The Long Game

 

For example, according to insurance giant Swiss Re, not acting on climate will destroy around 18 per cent of GDP by 2050. This may sound survivable, but the truth is that for many parts of the world, it simply is not. Low- lying and coastal cities like Miami, huge parts of Bangladesh, and all island nations will flood permanently. Some cities will become too hot to inhabit. We’re already seeing historical heat waves in India, the world’s second largest wheat producer. As a result, India’s wheat crops have been scorched, preventing the country from helping ease the global wheat shortages triggered by Russia’s invasion of Ukraine − which, coincidentally, was made possible by global investments in Russian oil.

Make no mistake: everything is interconnected, and the downside risk to a global economy will eventually reach 100 per cent.

The cost of doing nothing and continuing business as usual is only accelerating and advancing future risks. But investing in clean energy, electric vehicles, regenerative agriculture, low-carbon climate-resilient water infrastructure, and quality and affordable healthcare services are all critical and promising areas that will become multi-trillion-dollar markets over time. ESG investments target these crucial areas but will take time to show strong financial results. We’re talking about investing in ways that are different, shaping new markets, fueling entrepreneurial ventures, and reaching consumer segments we haven’t reached before.

So, we ask the important question: Isn’t that worth the wait? We certainly think it is.

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Ethical Boardroom is a premier website dedicated to providing the latest news, insights, and analyses on corporate governance, sustainability, and boardroom practices.

ethicalboardroom
Ethical Boardroom is a premier website dedicated to providing the latest news, insights, and analyses on corporate governance, sustainability, and boardroom practices.
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