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Why it's time to believe the hype behind ESG investing

Studies show socially conscious investing principles positively affect long-term, risk-adjusted returns

Apr 8, 2015 @ 1:38 pm

By Thomas Hoops

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Environmental, social and corporate governance investing — or ESG — has been frequently discussed over the years, often as the next big investing fad. This time, though, it's more than just talk.

Each day, more investors are coming to believe that focusing on ESG principles can help deliver what everyone wants: superior, risk-adjusted performance over the long term.

Assets under management in ESG investments are growing steadily, as both the number and type of options increase across asset classes. At the same time, the negative consequences of ignoring ESG principles have become obvious to companies, investors and the media. Some large global consulting firms have even explicitly incorporated ESG into their investment belief statements.

Would you believe much of the new focus is largely because of the millennial generation?

Before you scoff, consider this: Millennials stand to inherit $59 trillion by 2060. That's trillion, with a T. And they care about what their money supports and encourages as much as returns.

(Related: A deep dive on the rise of impact investing)

As they tell us in survey after survey, millennials want to invest the way they live. Their logic is blazingly simple: if they strive not to waste energy and water at home, they want to invest in companies that find creative ways to conserve resources; if they boycott the products of known polluters at the supermarket, they don't want to buy their shares.

Yet many financial advisers are continuing to ignore this trend.

Some have been reluctant to jump on the bandwagon over the years, concerned that ESG investments would hurt the performance of their portfolios. If considered simply a way of avoiding “sin stocks,” that view has merit, particularly in the short term. In times of rising oil prices, for example, stock prices of energy companies and other fossil fuel producers should rise. Those whose investment principles bar these stocks could underperform.

However, deeper analysis tells a different story: a number of studies show that ESG principles positively affect long-term, risk-adjusted returns.

In 2012, Deutsche Bank published “Sustainable Investing: Establishing Long Term Value and Performance,” which examined more than 100 studies of sustainable investing. It found that high ESG ratings correlated with a lower cost of capital in 100% of the studies; with market-based outperformance in 89%; and with accounting-based outperformance in 85%.

These numbers are eye-popping. They help to explain why investor attitudes toward ESG investing are changing dramatically — so much so that ESG currently captures more than $1 of every $6 in U.S. AUM, an increase of 76% since 2012.

It should be noted that the acronym “ESG” represents just the latest stage in the evolution away from merely screening out certain industries or companies. Most ESG portfolios do not simply avoid certain industries; they integrate industry-specific factors into the fundamental research process, and they favor companies that actively promote best practices on ESG issues.

(Related video: Cutting through the jargon around impact investing)

Fortunately for investors, high-quality options are increasing within and across asset classes. ESG choices have grown not only in assets under management but in sheer variety. There has been a veritable explosion in new ESG-oriented investment strategies and vehicles.

These include everything from index and smart-beta funds to quant strategies and different approaches to shareholder engagement. Entire asset allocations can be constructed consistent with ESG principles, including public and private equity, fixed income and alternative assets.

As a result, and perhaps unsurprisingly, more people of all ages want ESG in their portfolios.

At our ClearBridge Investments affiliate, all companies considered for investment are given an ESG rating, updated annually. This investment process can be collaborative: our portfolio managers work with companies that want to improve ESG performance through direct engagement and proxy voting. Like most asset managers, ClearBridge can also build custom portfolios based on specific client mandates.

A client comment illustrates ESG's appeal. According to Mark Callaway of The Indigo Group at Morgan Stanley, “We believe that ESG principles will be incorporated into almost all investments in the future. Looking back, I can see a time when my grandkids might say, 'You mean you knowingly invested in companies that were polluting or using sweat shop labor?'"

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.

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