The ESG Era

ESG assets are set to reach over $40 trillion – occupying almost a third of the total global Assets Under Management (AUM) – by 2025

2021 turned out to be the year of ESG (Environmental, Social, and Governance), as investors with climate and social agendas successfully pushed firms and regulators to make changes amid a record $649 billion being poured into funds focusing on environmental, social and corporate governance issues.

Reuters reported in December last year that through Nov 30, numbers were “up from the $542 billion and $285 billion that flowed into these funds in 2020 and 2019, respectively, (according to) the latest Refinitiv Lipper data. ESG funds now account for 10% of worldwide fund assets.

Stocks of companies rated highly for their sustainability efforts also notched gains. The MSCI World ESG Leaders’ index has risen 22% so far this year, compared with the MSCI World Index’s gain of 15%.”

ESG Investing

In a February article about the best ESG funds of 2022, Forbes Advisor reported that “ESG investing is a strategy that channels dollars to companies that meet stringent environmental, social and governance standards. Investing in the best ESG mutual funds, index funds and exchange-traded funds (ETFs) can help…support responsible corporate behaviour without sacrificing performance or incurring excessive fees.”

Like most others, ESG funds usually adopt one of two approaches to portfolio building – either passively tracking an index or actively picking research-based investments. Passive funds track and rely on third-party indices – selecting firms with ESG scores beyond a particular threshold – for investments and compliance issues.

Consider, for example, the MSCI KLD 400 Social Index. The index, set up in 1990, tracks 400 U.S. companies with “outstanding ESG ratings, and includes a mix of small-cap, mid-cap and large-cap companies.”

***Figure 1:*** *The MSCI KLD 400 Social Index; **Source:** MSCI*

As easy as investing in an Index Fund?

Short answer: no.

Here are some of the things you should know, according to Forbes:

“It isn’t one-size-fits-all”: Understanding the criteria funds use to define their ESG strategy is imperative before investing in an ESG fund. “It is crucial to get under the hood to make sure the fund’s core values line up with your own”, according to the Forbes report.

Stocks may also be rated differently by different analytic firms depending on where exactly they fall on the ‘socially responsible’ scale, thereby leaving ample wiggle room for portfolio managers.

***Figure 2:*** *Motivation for ESG integration; **Source:** MSCI*

“Consider a large cell phone provider that uses materials that are not biodegradable and will consistently contribute to pollution and be detrimental to the environment over time,” says Matthew Gaffey, a financial planner in Potomac Falls, VA. “On the other hand, this same company is very proactive in promoting diversity, fair compensation to women and several women serve in managerial roles. This company may satisfy the criteria of the portfolio manager, but leave the individual client wanting more.”

Standardisation of metrics: Since there isn’t a single criterion that makes companies ‘socially conscious’, there isn’t a reporting requirement either. Most of the data that determines ESG funds is self-reported, and hence cannot be held against a universal standard.

Assuming 15% growth, half the pace of the past five years, ESG assets under management could climb to more than a third of the projected $140.5 trillion global total by 2025. ESG assets are on track to reach $53 trillion, according to Bloomberg, up from $37.8 trillion by year-end. They jumped to $30.6 trillion in 2018 from $22.8 trillion in 2016.

Bloomberg opines: “A perfect storm created by the pandemic and the green recovery in the U.S., EU and China will likely reveal how ESG can help assess a new set of financial risks and harness capital markets.”