Much has been written about the rise of responsible investing and environment, social and governance (ESG) integration over the past decade. From 2014 to 2016, assets that systematically considered ESG factors in the investment process grew from USD 7.5 trillion to USD 10.4 trillion, with continued momentum over the past several years[i]. However, recent commitments to ESG integration (vs. values-based strategies) have yet to be tested by a significant market downturn. The spike in market volatility experienced in late 2018 has led some to question whether the consideration of ESG factors by investors will continue to flourish in a market environment characterized by investor fear and valuation corrections.
When I joined Sustainalytics in 2013, as the S&P 500 was finally crawling past 2007 levels, there was concern among proponents of responsible investing that an economic downturn could threaten the growth of ESG integration. This fear was predicated on the idea that another recession would drive institutional investors towards a narrower view of fiduciary duty that excludes the evaluation of ESG performance and risks. While apprehension about the effect of a bear market on ESG integration growth still lingers, the increase in sophistication and reach of ESG integration strategies over the past six years should not be ignored. The conversations I have with investors have broadly shifted from discussing why ESG factors should be considered, to examining the most effective way to do so. I am encouraged from working with a diverse set of asset owners and asset managers who demonstrate that the consideration of ESG research and ratings is not a peripheral exercise, but rather a meaningful and core element of their value proposition to generate superior risk-adjusted returns.
The proliferation of passive funds that use ESG inputs is an important feature of responsible investment growth, but a market with increased volatility promises to offer active managers an opportunity to demonstrate the value of their processes and ultimately stem the flow of assets to lower-cost index funds. ESG data has proven to be an important part of active management, in order to gain a more holistic understanding of risks and opportunities. When the CFA Institute asked its members why they consider ESG issues in investment analysis, the overwhelming response was to help manage investment risks.[ii] Recent guidance from the CFA Institute formalizes this view, explicitly outlining that material ESG information is an important component of a complete and thorough financial analysis for any actively managed fundamental portfolio[iii].
As a bear market increases earnings stress, it will also intensify the imperative to understand the underlying drivers of value creation such as corporate governance structures, customer loyalty and operational efficiency, which can potentially be better understood through ESG ratings.
Many of our clients with active strategies employ an ESG integration approach that systematically considers company exposure to controversial events, to manage downside risks. In a historical assessment of our incidents database we found that companies that avoided incidents outperformed the global market by 11 percent between 2014 and 2017. To highlight a recent example, Sustainalytics has rated PG&E with a Category 4 Quality & Safety controversy [scale of Category 1 (low)- Category 5 (severe)] since the company’s 2010 San Bruno pipeline disaster.[iv] As of October 2018, less than 1% of global Utilities companies had this severe of a controversy rating in this theme, clearly communicating a signal of exceptional risk. Subsequently, PG&E experienced a well-documented dramatic decrease in share price and filing for Chapter 11 bankruptcy.
A wealth of research from practitioners and academics supports the intuitive takeaway of the PG&E case. Bank of America Merrill Lynch found that an investor holding stocks with above average overall environmental and social scores would have avoided 90+% of the S&P 500 bankruptcies that have occurred since 2005[v], while BlackRock found commonalities between ESG performance and balance sheet strength, suggesting a link between ESG optimized portfolios and resiliency in downturns[vi].
Reflecting on the growth and advancement of ESG integration practices over the past six years, I am confident that ESG integration strategies and the responsible investment market are more robust than ever. This leads me to expect that an increasingly volatile or bear market environment will only serve to further illustrate the importance of incorporating ESG factors to better understand the full spectrum of investment risks and opportunities.
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