Strong Foundations: The Rise of ESG and Responsibility in Investing

Charlie Liechti, Milena Czaczkowska, Robin Haack

Setting the scene on ESG and Responsible Investment

At the beginning of 2018, there was $30.7 trillion sustainable investing assets under management across the five major markets of the world (GSIA, 19), following a 34% increase in the previous two years. By the end of 2018, assets in sustainable mutual funds and ETF’s alone had grown 56% (Sustainableinvest.com, 2019). It is therefore no surprise that 89% of firms say they will be devoting additional resources to sustainable investing in the next 1-2 years (Morgan Stanley, 2019).

The origins of ESG

The term ESG, referring to Environmental, Social and Governance factors, rose to popular use from a 2005 report called ‘Who Cares Wins’, a UN Global Compact report that was issued with the support of 20 financial institutions with $6TN in assets under management as well as funding from the Swiss Government.

At Alpha FMC, we define ESG integration as Incorporating E, S, and G risks and opportunities in the investment process in the pursuit of better decision-making. We use the term ‘Responsible Investing’ to encompass both ESG integration, as well as more specialist sustainable investment approaches such as Socially Responsible Investing and Impact Investing.

The underlying finding of the UN Global compact report was that a company’s success and investment performance is materially impacted by how the company confronts and manages the risks and opportunities of our fast-changing, globalised, and climate-sensitive world. The report argued that companies can increase shareholder value “while at the same time contributing to the sustainable development of the societies in which they operate.” The recommendation from the report to financial institutions was to “commit to integrating environmental, social, and governance factors in a more systematic way in research and investment processes.”

In the last decade, the following are some of the key events that have shaped the practice of ESG integration and prompted discussions on a global stage:

Where does ESG fit in?

Alpha has identified three broad investment approaches that incorporate ESG and/or sustainability factors. These are ESG Integration, Socially Responsible Investing and Impact Investing. Our spectrum above shows these in more detail with regards to intentionality. It demonstrates a spectrum of intentionality towards the investment, e.g. whether the investment has additional intended value outcomes.

ESG Integration refers specifically to the analysis of ESG factors within the investment process that have been shown to hold financially material influence, and, if integrated fully into the investment screening and decision-making process, should contribute positively to sustainable development. However, it is important to note that ESG integration can be applied across all investment strategies. This analysis can be done on a spectrum, from basic integration and consideration to fully embedding ESG principles and factors within the entire investment process. The resulting positive contribution to sustainable development will therefore range, depending on this level of integration. Ultimately, the growth in AUM and quantity of specialist sustainability funds only tells a fraction of the ESG story. A significant change to the industry is the movement towards integrating ESG considerations into every investment decision.

Socially Responsible Investing refers to investing to generate financial return whilst being conscious, and/or specific about how that return is earned. It includes investment strategies in which investors look for companies that are both “socially responsible” and present a financially compelling investment opportunity. During the research process for a Socially Responsible Investment, a company’s ESG scores are likely to form a component of the analysis process. However, these strategies are driven not only by ESG integration, but by the mission and values of the investor. This is likely to be accomplished through positive or negative screening or investing thematically.

Impact Investing refers to investing or wanting to generate financial return alongside measurable positive impact. Whilst we have established ESG has its primary focus on the reduction of companies and investors’ risks, and/or assessing  companies’ non-financial performance, Impact Investing involves looking through the lens of the company’s business model and its revenue generation. Frequently, we can look at Impact Investing as investments made into organisations that generate revenue from products and services that deliver solutions to societal problems.

Three reasons to care

1  Positive impact on performance

Following significant evidence that a better understanding of ESG risks and opportunities informs better long-term investment decisions, ESG integration provides a genuine opportunity to increase alpha and ultimately outperform competitor funds over time.

Early academic papers from authors such as  Eccles, Ioannou, and Serafeim (2011) provided evidence that “high sustainability companies significantly outperform their counterparts over the long-term.” More recent studies such as the aggregation of more than 2000 empirical studies by Friede, Bursch and Bassen (2015) concluded that a “large majority of studies” report positive findings between ESG and corporate financial performance.

Industry research has also proved this, for example

  • Oxford University and Arabesque partners – “80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance” (Oxford University | Arabesque Partners, 2015)
  • MSCI – ‘high-rated’ (using MSCI ratings) ESG companies tended to demonstrate high profitability, higher dividend payments and lower idiosyncratic tail (MSCI, 2017)
  • Amundi – “between 2014-2017, responsible investing was a source of outperformance in the Eurozone and North America” (Amundi, 2019)

2  Differentiation will drive commercial opportunity

Over the past 5 years, with growing AUM and significantly increased merger and acquisition activity in the Investment Management space, managers are being forced to win through scale or differentiation. Fully integrating ESG, and doing so more effectively and comprehensively than competitors, will not only provide a method of differentiation, but will also lay the foundation upon which more specific and differentiated offerings can be developed, such as bespoke Responsible or Positive Impact Funds. It is one step further in the direction of mass customisation of investment in line with investor preferences.

3  Asset Owners and underlying beneficiaries care

With growing debate around the sphere of fiduciary responsibilities, and how ESG fits in, Asset Owners are increasingly becoming more sensitive to ESG competence during the manager selection process. In 2018, approximately 55% of Asset Owners were considering ESG / Active Ownership in their selection of managers, and 53% were considering it in the monitoring of managers, (UNPRI, 18). 46% of Asset Owners consider track record the most important factor when selecting an ESG manager (BNPPAM, 19). These statistics show the attractiveness of an Asset Manager’s funds will therefore be directly affected by both their immediate ability to integrate ESG effectively, as well as their track record in doing so.

Ask yourself

About the Author

Charlie Liechti, Milena Czaczkowska, Robin Haack

Charlie is an Analyst at Alpha where he works across multiple work streams within the Alpha ESG and Responsible Investing proposition. He has supported Asset and Wealth Managers across a range of Target Operating Models design projects. Charlie has developed experience in sustainable investing strategy definition and ESG integration within the investment analysis process through his past experience in co-founding a sustainable investment fund whilst at University.

Milena is a Consultant at Alpha and is one of the initiators of the Alpha ESG and Responsible Investing (RI) Proposition. She leads the Luxembourg ESG & RI Proposition, is part of the global ESG Regulatory leadership initiative, and is the local representative for the European Digital Practice. Milena also heads the Luxembourg CSR Program and has deep expertise across regulatory transformation, post trade activities, and market strategy.

Robin is a Senior Manager at Alpha and oversees the ESG regulatory leadership initiative. His consulting experience spans strategy formulation, operating model redesign, and risk management for sell- and buy-side institutions.