Crowding-in, feedback loops and tipping points: The self-sustaining case for ESG
Sustainable investing creates a feedback loop that directly rewards those who follow its precepts – investors and firms alike – while bringing a better future within reach for all.
Many investors would like to align their portfolios with environmental, social and governance (ESG) principles. Yet they worry that this model – known broadly as sustainable investing – might deliver lower returns over time, and question whether such choices fall outside the scope of their narrow mandate as asset allocators.
Fortunately, it is becoming clearer with time and mounting evidence that ESG integration, whether applied broadly across investment portfolios or more narrowly in focused "impact" strategies (those with a stated goal of promoting positive ESG change), generates the returns necessary to justify its use. Further, many asset owners are explicitly calling for the adoption of sustainable investing, removing potential concerns about the responsibility of implementing it within portfolios. This trend appears to have reached a number of critical tipping points:
Flow of capital: The amount of investment capital aligned with sustainable investment is now sufficiently large and broadly distributed that investors will “crowd-in” capital to those investments that meet ESG criteria, raising their value (all else equal). The reverse will be true for those assets that cannot achieve compliance with ESG standards, leaving them subject to a valuation discount.
Cost of capital: The lower cost of capital available to firms that demonstrate higher standards of sustainability is an economic incentive that applies to both public and private entities. From the viewpoint of a investor, a lower cost of capital is attractive independent of broader sustainability benefits and should lead to greater inclusion in all types of porfolios.
Active allocation of capital: Improved and transparent ESG scoring metrics allow for the creation of ESG-aligned benchmarks and low-cost, near-passive investment strategies that track them. Against this baseline, a large community of active managers is taking sustainable investing a step further by identifying and rewarding not just the current high-scoring companies, but also those that are overlooked in public databases or are positioned to improve in the future.
The result is an emerging feedback loop that creates value for investors, both from the bottom up, within firms in the public and private markets, and from the top down across investor portfolios. In this article we explore the evolving landscape of sustainable investing and what it could mean for asset allocation decisions in the future.
Where capital flows, returns should follow
Sustainable investing has advanced furthest in Europe, but it’s rapidly gaining traction in the United States and Asia. To get a handle on current investor preferences, we first look at flows into strategies that can be characterized as sustainable (Exhibit 1). We recognize that the distribution of legacy allocations will remain skewed to traditonal strategies for some time. However, as incumbent strategies are turned over, the percentage of total assets invested in sustainable strategies should grow quickly.
Flows into sustainable strategies have increased significantly in the past few years
Exhibit 1: Flows into sustainable strategies as a percentage of total inflows by region
While flows data is already compelling, it actually understates the impact of ESG on the total investment universe. Many active managers are now incorporating ESG metrics into their investment processes, extending the reach of ESG even to strategies without a stated focus on sustainability. In this way, all portfolios should exhibit increasing alignment over time.
There has also been a steady rise in environmental (E) and social (S) scores over time, although evolving data sets used to evaluate governance (G) scores have led to greater volatility of this element (Exhibit 2). Regardless, the general trend of slow and steady improvement is reassuring – suggesting that the metrics are not easily gamed by firms who might otherwise take easy steps to improve their scores materially.
Average ESG scores of companies in the S&P 500 have been trending upwards
Exhibit 2: Evolution of E/S/G component scores for the S&P 500
Performance data supports the idea that sustainable investing has been positive for investors. Since the 2008-2009 financial crisis, portfolios comprised of firms with high ESG scores have outperformed broad benchmarks and low-ESG subsets
ESG has been positive for returns
While some portion of this performance may relate to the temporary effect of increased flows, there are good reasons to believe that sustainable investing brings more lasting benefits. In many respects, companies that score well on ESG metrics also align with the broad “Quality” factor – sharing higher return on equity and lower observed volatility.
Integrating ESG factors can generate long-term outperformance
Exhibit 3: Higher ESG scores have been consistent with stronger investment performance
From exclusion to inclusion
Despite growing evidence to the contrary, some investors still assume that ESG considerations impose a drag on performance by limiting the investment opportunity set, reducing diversification and excluding some otherwise attractive investment opportunities. This outdated view was more relevant to socially responsible investing (SRI) – an earlier form of what has evolved into ESG – that was built around rigid criteria to exclude non-compliant firms.
SRI investors imposed their views within portfolios bluntly: broad exclusions on companies engaged in business activities deemed to be objectionable, even in cases where the objectional activity was only a small part of the overall business. The result was predictable: companies, and even whole industries, were ruled out of bounds, leaving the the portfolio less diversified and usually delivering lower returns. The lost return potential may have been less important for many investors than the principle at stake, and they knowingly bore the cost of this trade-off.
Modern sustainable investing, in contrast, tends to take a more nuanced and inclusive application of ESG metrics to the security selection process. This begins with a public and transparent ESG scoring system, such as the widely followed MSCI ratings, that ranks companies in the public markets across a range of environmental, social and governance metrics – providing a numerical score for each sub-category, as well as the overall enterprise (Exhibit 4).
ESG scores are widely distributed
Exhibit 4: Distribution of ESG scores by region
A key benefit of this model over the more exclusionary SRI framework is that it does not establish a strict “bright line” criterion for eligibility, but rather allows for a relative ranking of companies against one another. It also allows investors to seek increased ESG metrics across a broadly diversified portfolio or tilt their strategy towards particular criteria (E, S, or G) that may be more or less important to them.
Active management is key to the future of sustainable investing
At present, investors may benefit from simply owning high-scoring ESG firms as capital moves from traditional strategies to those with a sustainable focus, and as investment firms evolve their investment processes to incorporate ESG scoring. Eventually, however, this migration should be complete and the value of a given firm’s level of perceived ESG compliance will be fully priced in. Once markets have adjusted in this way, active management will be critical.
This is an important point. Active managers that evaluate firms directly can add value in two ways: first, by applying their own proprietary judgement to the rankings process and scoring companies independently; and second, by identifying companies that may have low ESG scores today but are likely to improve over time (Exhibit 5). In many respects, this process resembles bottom-up equity and credit research that takes place today, in which active managers seek to develop an informed view of each firm on its own merits, but also look for firms whose valuation (or ESG rating) is not fully appreciated by the market or independent raters.
Asset managers who can integrate ESG analytics into a proven investment process, and who possess the scale to cover the broadest possible set of companies globally across the capital structure, will have an advantage. These larger asset managers also tend to have better access to corporate management teams and potentially more direct influence to promote change through capital allocation decisions. Smaller, specialized teams are likely to play a more meaningful role in narrowly defined thematic strategies, or in private market impact strategies, which can take maximum advantage of their skill and where fewer external factors influence success or failure.
Sustainability metrics can be tailored to address sector-specific criteria
Exhibit 5: Internal composition of ESG score for specific sectors (total for each sector is 1.0)
Sustainability within a Strategic Asset Allocation
Asset allocators remain focused on return targets and risk budgets. However, the growing availability of sustainable investment strategies across most asset classes ensures that building diversified asset allocations is largely unaffected by the decision to incorporate ESG. The market continues to evolve and investors are able to access numerous types of sustainable strategies. Some examples include:
|Broad public market ESG||
A fixed income mutual fund focused on the investment grade credit markets, which integrates ESG metrics into the investment process along with more traditional criteria, such as credit quality and business stability
|Targeted environmental or social focus||An equity mutual fund focused on long-term environmental sustainability trends that invests primarily in sector leaders while also allowing for lower-scoring ESG names that are likely to improve|
|Narrow thematic portfolio||An ETF focused on technology companies that have established leadership positions in the fight against climate change|
|Private impact strategy||A private equity fund specifically targeting businesses that have ownership and management teams with high levels of women, minorities and other underrepresented groups|
Looking to the future, achieving higher aggregate ESG scores across the full asset allocation may become a more common objective for institutional investors. To increase flexibility, investors can blend allocations to achieve their overall target. For example, investors could use high-scoring strategies to offset sectors elsewhere in the portfolio that have low ESG scores but offer high returns. This could be a particularly compelling attribute of thematic or impact strategies, which might be valued as much for their ESG score as for their intrinsic return potential.
Changing the future through capital allocation
Until very recently, the allocation of capital by institutional investors could be described between the X and Y axes of a risk and return graph. The investment world expended a great deal of time and effort to understand and quantify the behavior of portfolios within these dimensions; it devoted less time and effort to understanding how this process affects the world at large.
Today, investors are not only aware of the broader impact of their decisions, they are starting to realize that they possess agency to shape the future as well. Sustainable investing is a direct response to visible flaws in the capital allocation process which have created and perpetuated negative consequences – from climate change to inequality.
Few forces at our disposal have the power to impact the future more directly than capital allocation. The recipients of capital thrive and those who are starved of capital fade away. Choices made by long-term investors today will have consequences not just for the next quarterly performance report, but across our economy and society for years and decades to come.
The alignment of vast pools of long-term capital with environmental, social and governance principles has the potential to generate positive returns for both society and portfolios. Sustainable investing creates a feedback loop that directly rewards those who follow its precepts – investors and firms alike – while bringing a better future within reach for all.