The ESG Integration Paradox

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous. Yet, a written policy is not a reliable indicator of a firm's commitment. Actual ESG incorporation practices vary greatly, with most investment managers falling well short of full integration. Only a few firms seem to be using ESG factors to deliver alpha, hence, the paradox. If not implemented wholeheartedly, responsible investing can lead to lower financial returns. So, why have so few investment managers gone all the way? The paradox involves a “valley” of lower returns where portfolios first absorb the costs of ESG integration before the promised benefits materialize. In the early days of ethical investing, the focus was on using negative screens to exclude certain companies for moral or ethical reasons but lower financial returns are inherent to exclusionary screening. Hard exclusions force managers to tradeoff certain risks for others. So, for example, if the market discounts tobacco stock prices to account for changing consumer behavior, eventually tobacco stock prices become attractive again as, indeed, has been the case over the last two decades. Exclusionary screening alone is a self‐limiting strategy. By contrast, ESG strategies range from active ownership and engagement, to positive screening (selecting for certain attributes), to relative weighting (sometimes called “best‐in‐class selection”), to risk factor investing, to full integration. Because the relationship between an asset manager's ESG efforts and its risk‐adjusted performance is not classically linear, asset owners should look for managers that are on the upward slope of the ESG intensity curve and are fully committed to advancing up it.     

The Next Wave of ESG Integration: Lessons from Institutional Investors

In this panel that also took place at the recent SASB Symposium, senior representatives of four leading institutional investors—BlackRock, Ca lPERS, Ca lSTRS, and Wells Fargo—emphasize the relevance of ESG data for “mainstream” investors and the importance of integrating it with traditional fundamental analysis rather than viewing it as a separate set of reporting responsibilities. Moreover, the logical place for integrating ESG information is in the most forwardlooking section of financial reports, the “Management Discussion and Analysis,” or “MD&A,” which would be strengthened by including more and better information about the companies' ESG risks and initiatives. Some panelists noted that ESG information is likely to be valued by investors because of its ability to shed light on “idiosyncratic” risks that are not captured by the traditional risk factors that have long dominated asset pricing models. Others described ESG information as helpful in evaluating and comparing the “quality” of management in portfolio companies. But all agreed that efforts like the SASB's to standardize ESG data are essential to successful integration of that data into the decision‐making process of large mainstream investors. And as the panelists also made clear, there is an important generational component to the growing movement to integrate ESG into mainstream investing, with Millenials—and particularly Millenial women—showing especially strong support.     

Responsible Investors: Who They Are,What They Want

This article by a long‐time partner in Domini Social Investments, a well‐known socially responsible investment firm, begins by describing four different approaches that institutional investors have currently adopted as they account for environmental, social, and governance (ESG) considerations in their investment decisions: (1) the incorporation of internationally accepted ESG norms and standards (as set forth in, for example, the FTSE4Good Indexes); (2) the use of industry‐specific ESG ratings and rankings (such as those used for the Dow Jones Sustainability Indexes); (3) the integration of ESG considerations into stock valuation (as advocated, for example, in the Principles of Responsible Investment); and (4) the identification of companies whose business models successfully address the most pressing societal needs (often referred to as “impact investing”). The article then seeks to answer the question: what corporate ESG programs and policies can be most effectively used by managers seeking to attract institutional investors using these different approaches? The author describes three kinds of corporate ESG programs. In one approach, corporate managers focus on strengthening relations with non‐investor stakeholders, including employees, the environment, and local communities. In the second approach, corporations seek to create “shared value” by emphasizing products and services that help address society's most pressing needs. The third approach focuses on identifying and addressing the firm's industry‐specific ESG performance indicators (KPIs) that are most material to stockholders and other stakeholders. Given institutional investors' growing commitment to the incorporation of ESG concerns, corporate managers should understand the range of investors' approaches to ESG and how to account for them in their strategic planning. At the same time, they are encouraged to develop comprehensive ESG policies and goals, devote adequate resources to their implementation, and communicate efforts effectively to these investors and to the public.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

ESG Investing in Graham & Doddsville

The author describes how and why the world's best “business value investors” have long incorporated environmental, social, and governance (ESG) considerations into their investment decision‐making. As the main source of value in companies has increasingly shifted from tangible to intangible assets, many followers of Graham & Dodd have delivered exceptional investment results by taking an “earnings‐power” approach to identifying high‐quality businesses—businesses with enduring competitive advantages that are sustained through significant ongoing investment in their core capabilities and, increasingly, their important non‐investor “stakeholders.” While the ESG framework may be relatively new, it can be thought of as providing a lens through which to view the age‐old issue of “quality.” Graham & Dodd's 1934 classic guide to investing, Security Analysis, and Phil Fisher's 1958 bestseller, Common Stocks and Uncommon Profits, both identify a number of areas of analysis that would today be characterized as ESG. Regardless of whether they use the labels “E,” “S,” and “G,” investors who make judgments about earnings power and sustainable competitive advantage are routinely incorporating ESG considerations into their decision‐making. The challenge of assessing a company's sustainable competitive advantage requires analysis based on concepts such as customer franchise value, as well as intangibles like brands and intellectual property. For corporate managers communicating ESG priorities, and for investors analyzing ESG issues, the key is to focus on their relevance to the business. In this sense, corporate reporting on sustainability issues should be viewed as analogous to and an integral part of financial reporting, with a management focus on materiality and relevance (while avoiding a “promotional” approach) that is critical to credibility.     

Private market impact investing firms: Ownership structure and investment style

Impact investing and ESG investing are specific “ethical” investing types integrating social, environmental, and moral values with financial goals. Despite receiving heightened scholarly attention, the difference between impact and ESG investing is largely unexamined, and it is not clear how they differ from conventional investment. To explain the differences between ESG, impact, and conventional investing, this paper draws on a dataset of over 8000 private market investment (PMI) firms. It compares impact, ESG, and conventional investment across firm characteristics, investment preference, and ownership. Results show that impact investors are more likely to be owned by the government, focusing on agriculture, cleantech, and education while avoiding “sin” industries like gambling and tobacco.     

Integrating Sustainability Into Capital Markets: Bloomberg LP And ESG's Quantitative Legitimacy

The rise in prominence of environmental, social, and governance data has been driven in large part by a growing interest among investors who seek to gain an edge through the incorporation of such data in their investment decision‐making. There are, however, several significant obstacles to the integration of ESG data into mainstream investing analysis. Perhaps most important, while finance today is a fundamentally quantitative discipline, ESG is often qualitative. Moreover, the ESG data that is available is incomplete and inconsistent, due largely to a reliance on voluntary reporting by individual companies. In short, ESG has not yet earned its quantitative legitimacy in the eyes of the investor community. Nevertheless, recent work in the area of stranded asset values has provided Bloomberg LP, a leading provider of financial data and analytics, an opportunity to “bridge theory and practice” by translating the stranded assets framework into a first‐cut valuation tool designed for mainstream financial analysts. The tool offers a quantitative introduction to an ESG issue that the authors believe will eventually become an important focus of many investment decision‐makers' analysis. While the tool continues to evolve in analytical sophistication, the authors “preview” it here in its early form as one step towards Bloomberg's broader vision of “sustainable finance,” and the company's role in supporting the quantitative maturation of ESG through the twin engines of standardization and disclosure.     

ESG Integration in Investment Management: Myths and Realities

The number of public companies reporting ESG information grew from fewer than 20 in the early 1990s to 8,500 by 2014. Moreover, by the end of 2014, over 1,400 institutional investors that manage some $60 trillion in assets had signed the UN Principles for Responsible Investment (UNPRI). Nevertheless, companies with high ESG “scores” have continued to be viewed by mainstream investors as unlikely to produce competitive shareholder returns, in part because of the findings of older studies showing low returns from the social responsibility investing of the 1990s. But studies of more recent periods suggest that companies with significant ESG programs have actually outperformed their competitors in a number of important ways. The authors’ aim in this article is to set the record straight on the financial performance of sustainable investing while also correcting a number of other widespread misconceptions about this rapidly growing set of principles and methods: Myth Number 1: ESG programs reduce returns on capital and long‐run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets; and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. Myth Number 2: ESG is already well integrated into mainstream investment management. Reality: The UNPRI signatories have committed themselves only to adhering to a set of principles for responsible investment, a standard that falls well short of integrating ESG considerations into their investment decisions. Myth Number 3: Companies cannot influence the kind of shareholders who buy their shares, and corporate managers must often sacrifice sustainability goals to meet the quarterly earnings targets of increasingly short‐term‐oriented investors. Reality: Companies that pursue major sustainability initiatives, and publicize them in integrated reports and other communications with investors, have also generally succeeded in attracting disproportionate numbers of longer‐term shareholders. Myth Number 4: ESG data for fundamental analysis is scarce and unreliable. Reality: Thanks to the efforts of reporting and investor organizations such as SASB and Ceres, and of CDP data providers like Bloomberg and MSCI, much more “value‐relevant” ESG data on companies has become available in the past ten years. Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets. Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non‐financial” considerations when investing in companies.     

Integrating Systemic Risk into Modern Portfolio Theory and Practice

Conventional wisdom holds that the performance of investment managers should be measured against some broad market index such as the S&P 500. The broad market averages provide a useful benchmark because they are assumed to be beyond the influence of investment managers and provide a way of capturing what financial economists call “systematic risk,” which is the part of total risk that cannot be avoided through portfolio diversification. But one clear limitation of such an approach to performance evaluation is that by focusing on risks and rewards at the portfolio level only, it fails to consider risks and rewards at a systemic level, where the performance of all portfolios is increasingly likely to be affected. The author begins by making the case that the performance evaluation and collective decision‐making of investment managers could have the effect of increasing the level of systematic risk in both the markets and the real economy. Then, after suggesting that the strength or weakness of environmental, social, and governance (ESG) frameworks can have substantial effects on overall market returns, he discusses a number of efforts currently underway to integrate ESG factors into portfolio‐level decision‐making. The author closes by urging asset owners to take the following three steps to help bridge the gap between investment decision‐making and ESG consequences: (1) acknowledge the connection between investment decision‐making and systems‐level risks and rewards; (2) determine which systemic frameworks are most appropriate and useful for their purposes; and (3) implement investment practices that allow them to manage systemic‐level risks and rewards while simultaneously achieving competitive financial returns in their portfolios. With the help of new measurement and management tools, asset owners can strengthen systemic frameworks, communicate the importance of ESG performance to their investees and investors, and align their efforts with those of governmental and non‐governmental organizations to limit systemic risk.     

How to Integrate ESG into Investment Decision‐Making: Results of a Global Survey of Institutional Investors

The authors review the findings of their global survey of 582 institutional investors that were either practicing or planning to practice some degree of integration of environmental, social, and governance (ESG) factors into their investment decision‐making process. The investors were evenly split between asset owners and asset managers, equity and fixed income, and across the three regions of the Americas, Asia Pacific, Europe, Middle East, and Africa. The survey explored reasons for ESG investing; the barriers to such investing and investor approaches to overcoming them; and the time frames used for making investment decisions, evaluating the performance of managers, and awarding compensation. The authors report finding that the commonly perceived barriers to ESG integration—the belief that ESG integration requires sacrificing returns, that fiduciary duty prevents one from doing so, and unrealistically short‐term expectations for ESG to deliver outperformance—were not as great as commonly believed. The biggest barrier is the lack of high quality data about the performance of companies on their material ESG factors—a scarcity that the authors attribute to the lack of standards for measuring ESG performance and the lack of ESG performance data reported by companies. The results were very similar between asset owners and asset managers, equity and fixed income, and across regions. However, the investment horizons of asset owners were notably longer than those of asset managers, and the same was true of equity vs. fixed income investors. Investors in the Americas were more patient about time frames for seeing outperformance from ESG, while those in Asia Pacific were the least patient. There were also differences across regions in how to overcome the barriers to ESG integration.     

Coping with impact investing antagonistic objectives: A multistakeholder approach

Impact investing (II) aims to achieve positive social and environmental impact and create blended value through sustainable value propositions. Building and expanding on a diverse and growing research corpus on socially responsible investing (SRI), social impact bonds (SIB) and social enterprises our study investigates the structuring elements of impact investing, its dynamics and trajectory. A particular emphasis is placed on the complex web of interactions among numerous stakeholders (i.e. banks, institutional investors, portfolio managers, public, for-profit and nonprofit organizations and social enterprises) with opposing objectives and antagonistic assets in sourcing and channeling financial resources. This paper highlights the importance of adopting a multistakeholder approach when examining the financial ecosystem within which II intermediaries operate and collaborate achieve maximum social and environmental impact.     

ESG for All? The Impact of ESG Screening on Return,Risk, and Diversification

A large body of research has documented a positive relationship between different measures of sustainability—such as indicators of employee satisfaction and effective corporate governance—and corporate financial performance. Nevertheless, many investors still struggle to quantify the value of ESG to investment performance. To address this issue, the authors tested the effects of using different ESG filters on an investable universe that serves as the starting point for a fund manager. In this way, they attempted to determine the extent to which ESG data can add value to any investment approach, regardless of preferences towards sustainable investing. The authors report “an unequivocally positive” contribution to risk‐adjusted returns when using a 10% best‐in‐class ESG screening approach (one that effectively removes companies with the lowest 10% of ESG rankings), both on a global and a developed markets universe. More specifically, as a result of such screening, both the global and developed markets portfolios show higher returns, lower (tail) risk, and no significant reduction of diversification potential despite the reduction in the number of companies. Use of a 25% screening filter was also found to add value, especially by reducing tail risks, but with a larger deviation from the unscreened universe. Overall, then, the authors’ finding is that the incorporation of ESG information contributes to better decision‐making in every investment approach, with the optimal configuration depending on a fund manager's preferences and willingness to deviate from an unscreened benchmark.     

Bridging Sustainability and Finance: The Value Driver Adjustment Approach

Even though most large corporations view sustainability considerations and concerns as having the potential to affect their revenue and profits, and studies have shown that sustainability can affect stock returns, investors and corporate managers continue to struggle to incorporate such concerns into their financial decision‐making. As a consequence, the valuation effects of sustainability issues are not fully reflected in either the valuation of companies by investors or in capital investment decisions by corporate managers. The author argues that sustainability can be integrated into both of these kinds of financial decision‐making by linking it to business models, competitive positions, and value drivers using what the author calls a “value‐driver adjustment” (VDA) approach. The basic idea is simple: material sustainability issues affect business models and competitive positions, which in turn affect the company's value drivers—notably, sales, margins, and capital. The VDA approach explicitly considers these linkages by taking three steps: (1) identifying a company's material sustainability issues; (2) analyzing how these issues are expected to affect the company's business model and competitive position; and (3) quantifying the effects of such changes in business model and competitive position on the company's value drivers, including its cost of capital. In the first part of the article, the author provides an investor perspective that shows how sustainability can be integrated into investment decisions by asset managers. There he explains how and why ESG integration has so far failed to become mainstream, and what needs to be done to make it successful. The second part of this article takes the corporate perspective and shows how sustainability can be linked to value drivers using much the same ingredients as in asset management, but slightly different tools that can help corporate managers incorporate sustainability concerns into strategy and operations, including the finance function. And in closing, the author brings together corporate and investor perspectives while showing how sustainability programs can be used to make the relationship between companies and their shareholders both stronger and longer‐lasting.     

Sustainability priorities,corporate strategy,and investor behavior

Using a sequential experiment, this study examines whether integration of material environmental, social, and governance (ESG) priorities into corporate strategy impacts investors’ short‐ and long‐term stock price assessments and investment allocation. In our examination, we consider the potential moderating effect of financial performance. We find that integration of ESG priorities into strategy does not have a significant effect on investors’ price assessments or investment allocation. This is true regardless of the trend in the company's financial performance. Our results hold across various demographics and the levels of investment knowledge and investment experience. Investors’ perception of relevance and reliability of material ESG information, however, has a mediating effect on their long‐term price assessment and investment allocation. Overall, our findings suggest that any future requirements on disclosure of ESG information by regulators and standard setters should aim to improve investors’ perception of the relevance and reliability of that information.     

Is it costly to be both shariah compliant and socially responsible?

Positive ethics associated with socially responsible investments (SRI) is challenging the limits of Islamic investments' conservative approach to promote corporate social responsibility. In this study, we test the integration of social performance measures (companies the most virtuous or high-rated in terms of environmental, social, and governance (ESG) issues) in Islamic portfolios using KLD social ratings. We seek to determine the financial price of complying both to Islamic investment and SRI principles. To do so, we measure the financial performance of self-composed Islamic portfolios with varying ESG scores. The results indicate no adverse effects on returns due to the application of ESG screens on shariah-compliant stocks during the 2007–2011 periods while reporting substantially higher performance for the portfolios with good records in governance, products, diversity, and environment issues. On the opposite, a negative performance is associated with an SRI strategy of disengagement from shariah-compliant stocks with community and human rights controversies. Our performance measures are controlled for market sensitivity, investment style, momentum factor, and sector exposure.     

Environmental,social and governance reporting in annual reports: A textual analysis

Considering environmental, social, and governance (ESG) factors becomes increasingly important for companies and investors. However, “ESG” is not clearly defined so far and, therefore, it is difficult to measure the ESG activity of companies. We analyze the extent and changes in 10‐K reports and proxy statements on ESG, using a textual analysis and creating an ESG dictionary. The results show an average of 4.0 % ESG words on total words in the reports. The ESG word list with 482 items can be used to quantitatively examine the extent of ESG reporting, which will be helpful especially for SRI investors. Our classification of 40 subcategories allows a highly granular analysis of different ESG related aspects. Moreover, indications for a relation between changes in reporting and real events, especially negative media presence, are detected. Regulatory bodies have to be aware of the use of such words and how they are used.     

Hidden Gem or Fool’s Gold: Can passive ESG ETFs outperform the benchmarks?

Using a unique and extensive dataset of 121 socially responsible investing (SRI) equity exchange-traded funds (ETFs) from January 2010 to December 2020, this study examines how passive SRI ETFs perform compared with their non-SRI benchmarks composed of S&P500 ETFs. Over the full sample period, our results show that an equally weighted SRI ETF portfolio underperforms its benchmark portfolio. Notably, we do not find significant differences in the two portfolios’ performance in the second half of our sample period. However, in the last two years, the SRI ETF portfolio significantly outperforms the benchmark. For the SRI investment strategies, we show that positive screening (or inclusion) rather than negative screening (or exclusion) can beat the benchmark portfolio. In particular, environmental inclusion screen provides significantly higher abnormal returns. Finally, we find that SRI ETFs’ performance can be explained by increasing industry competition and declining market concentration.     

Style and performance of international socially responsible funds in Europe

This paper analyses the performance and investment styles of internationally oriented Socially Responsible Investment (SRI) funds, domiciled in eight European markets, in comparison with characteristics-matched conventional funds. To the best of our knowledge, this is the first multi-country study, focused on international SRI funds (investing in Global and in European equities), to combine the matched-pairs approach with the use of robust conditional multi-factor performance evaluation models, which allow for both time-varying alphas and betas and also control for home biases and spurious regression biases.In general, the results show that differences in the performance of international SRI funds and their conventional peers are not statistically significant. Regarding investment styles, SRI and conventional funds exhibit similar factor exposures in most cases. In addition, conventional benchmarks present a higher explaining power of SRI fund returns than SRI benchmarks. Our results also show significant differences in the investment styles of SRI funds according to whether they use “best-in-class” screening strategies or not. When compared to SRI funds that employ simple negative and/or positive screens, SRI “best-in-class” funds present significantly lower exposures to small caps and momentum strategies and significantly higher exposures to local stocks.     

Morgan Stanley Perspectives on Sustainable Investing: Acceleration and Integration

The CEO of Morgan Stanley's Institute for Sustainable Investing discusses recent developments in the field since the founding of the Institute three years ago. The position of the Institute, which works across Morgan Stanley businesses as well as with external partners, provides a unique vantage point for assessing both the company's and the financial industry's progress in advancing the goals of sustainability. Since its inception, the Institute has focused on measuring investor interest and highlighting the performance realities of sustainable investing strategies, with the ultimate goal of helping to increase the adoption of such strategies by not only Morgan Stanley's clients, but throughout the industry. Drawing on its own survey data and on the research and views of the Institute's internal and external collaborators, the author describes not only the acceleration of investor interest and the emergence of new players, but also the progressive integration of sustainability with more traditional methods as ESG issues move from being peripheral to “material” and “strategic” considerations. Such integration is helping to ensure that sustainability concerns—and corporate efforts to deal with them—will prove more than just a temporary trend and assume a prominent, and permanent, position in the dialogue between companies and investors.     

Millionaire investors: financial advisors,attribution theory and gender differences

To date little attention has been paid to how social cognitive bias can influence how financial advisors interpret and respond to the needs of millionaire investors, and if this varies depending on the gender of the investor. This research investigates whether experienced professional financial advisors who work with millionaire investors make different attributions for the control and knowledge that investors have of their investments, and if they make different investment portfolio recommendations to equivalent male and female investors. Using methodology novel to finance, this vignette-based study that controls for gender finds evidence that professional financial advisors judge millionaire female investors to have less control over their investment portfolios relative to men. Empirical results also show that female advisors judge women to be less knowledgeable about investments than men. Despite such perceptual differences, advisors recommend equally risky portfolios to male and female investors. These results have implications for wealth management institutions and the monitoring of financial advisors for millionaire individuals.