ESG performance and key drivers
Historically, equity investors were placed in one of two camps, a value or growth investor. Over the years, the types of equity investment styles have increased, to now include strategies such as, factor and environmental, social, and corporate-governance (ESG) investing. With momentum driven by investors, who are more willing to invest in their beliefs and values, Wall Street firms are critiquing companies based on their sustainability factors or ESG standards. There is a growing belief that environmentally conscious companies that manage their internal and external relationships well and maintain strong corporate governance will experience sustainable growth into the future.
Choosing an ESG strategy is not as simple as risk/return analysis
Innovation of investment products have provided financial advisors a plethora of options that they must understand in order to determine the most suitable investments to help achieve their client’s objectives.
The decision to include or not include ESG investments into a client’s portfolio is more than just focusing on the risk-return trade-off and diversification benefits they may or may not provide. The decision may come down to investors feeling morally compelled to invest in companies that follow the strict ESG guidelines.
Next, we evaluate some of the benefits and drawbacks to ESG investing that financial advisors may want to consider before implementing the strategies into a client portfolio.
Benefits to ESG Investing
There is a growing belief that environmentally conscious companies who manage their internal and external relationships well and maintain strong corporate governance will experience sustainable long-term growth into the future.
Your investment can materially impact society and the environment as a whole. You can vote with your dollar for causes that matter, while investing in something you are passionate about.
It provides investors with the opportunity to reward ethical companies, who in turn, should experience long-term sustainable growth.
Chasing returns is one issue that plagues investors as they have the “fear of missing out” syndrome. Investors who focus on investing in a cause they are passionate about are more likely to buy and hold, rather than try to time the market, when they believe their investment will make a better tomorrow.
Potential Pitfalls to ESG Investing
A challenge in ESG being relatively new is there are multiple interpretations of ESG. Investing in companies who place emphasis on ESG seems straight forward, but it means different things to different people. ESG standards are becoming more commonplace, however, portfolio managers may differ in their ESG interpretations, while individual investors may have differing opinions on what they think socially and economically sustainability should look like.
Lack of Analysis
Due to the newness of the investment style and its subjective nature, it is difficult to find tools that allow financial advisors the ability to conduct comprehensive analysis on different products while having to consider the unique interpretations of ESG. MSCI ESG Research provides financial advisors an application to analyze products, but until there are more comprehensive applications, this will remain an obstacle.
As we previously mentioned, the decision to invest in ESG strategies is oftentimes more than just about performance. However, people invest their money in hopes of securing a financial goal in the future, in which, return and risk will be primary factors in achieving that goal. Some investors may place more emphasis on ethics vs. performance, which may hinder overall portfolio performance.
In our previous ESG research, we discovered that ESG strategies have narrowed the performance gap with non-ESG strategies, so it’s important to not completely overlook the performance and risk characteristics of an investment when incorporating ESG strategies in a client’s portfolio.
Incorporating ESG strategies in a client portfolio in large part comes down to personal feelings on environmental, social, and corporate-governance standards. Clients may be willing to sacrifice some performance in order to vote with their dollars on topics they are most passionate about. Additionally, financial professionals will need to overcome the lack of analytic applications to find the best strategy that falls in-line with the client’s unique interpretation of ESG investing.
Individuals and corporations alike are putting a greater emphasis on reducing their carbon footprint, which provides investment opportunities for investors. Investment management companies are listening, as they are providing investors with an expanding array of compelling stories. There are many reasons to include ESG strategies in your client’s portfolio, however, it is important to understand the drawbacks that exist when considering and evaluating ESG investments.
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