Socially responsible investing is coming of age

ESG investing continues to gain momentum, even if it's not mainstream just yet

Mar 6, 2016 @ 12:01 am

By Jeff Benjamin

Fueled by younger investors, women, and growing political support, investing based on social and environmental ideals is gaining momentum. Even if it doesn't quite feel like a mainstream concept yet, it's here and it's expanding rapidly.

In the United States, at least $7 trillion is invested in strategies focused on environmental, social and corporate governance causes, so-called ESG strategies, according to The Forum for Sustainable and Responsible Investment. That's up from $3.7 trillion in 2012 and $639 billion in 1995, according to Envestnet PMC.

The dollar amounts are considerably smaller when the scope is narrowed to U.S. mutual funds dedicated to ESG strategies, but the trend is similar. There's more than $135 billion invested in 150 ESG-dedicated mutual funds, which is up from $93 billion in 120 funds at the end of 2010, according to Morningstar.

Whether the recent growth patterns are impressive enough or not, virtually every corner of the financial services universe is now at least dabbling in the ESG space for reasons that range from addressing climate change and social injustices to simple economics.

Just last week, Morningstar Inc. started scoring mutual funds based on ESG metrics to give advisers and investors a way to judge their performance in these areas. Initially, 20,000 funds have been scored.

ESG-focused US mutual funds
Source: Morningstar, Inc.


There are still plenty of naysayers, and there probably always will be, who insist that investing is about making money first, while social and environmental issues are noble impediments to that cause. But the momentum is clearly on the side of the swelling ESG movement.

Contrary to a couple of decades ago, it might be more difficult today to find a major financial services firm that is not dedicating some resources to ESG investing.

“I've seen more interest in the past two years than I've seen in the past 17 years,” said Joe Keefe, chief executive of Pax World Management, which launched its socially-responsible Pax World Balanced Individual Fund (PAXWX) in 1971, a year after the first Earth Day.

Mr. Keefe said the general idea of integrating investing strategies with causes and factors historically viewed as non-financial has the momentum of data and demographics on its side.

“Women and millennials are two of the fastest growing segments of the investing public, and they both want ESG investments,” he said.


In fact, millennials, those people currently between the ages of 18 and 34, are expected to represent a full third of U.S. adults by 2020.

That figure alone helps explain why ESG efforts are becoming so common through the financial services industry.

$7 Tinvested in strategies focused on environmental, social and corporate governance causes

“We're seeing a systematic increase in demand coming from almost every investor segment,” said Hilary Irby, managing director and head of the investing with impact initiative at Morgan Stanley.

“I wouldn't say it's just a niche part of our business, because clients are asking about it, and it's growing on a pretty consistent basis,” she said of the impact investing platform that launched in 2012.

In terms of interest from financial advisers, Ms. Irby said that is often driven by their clients.

(More ESG insights: The top-performing socially conscious funds)

“The level of pull we are identifying now is from advisers who are getting questions from clients or who have made it a part of their practice,” she said.

Leon LaBrecque, managing partner at LJPR Financial Advisors, can certainly relate to the push from clients to increase his focus on ESG investments.

Although Mr. LaBrecque admits he is not a big believer in socially conscious investing, he typically obliges his inquiring clients with an allocation to the Vanguard Social FTSE Index Fund (VFTSX).

Since the start of the year, the fund is down 7.12%, which compares to a 5.25% drop for the S&P 500 Index, and a 5.95% drop for Morningstar's large-cap blend category.

“I guess about 10% or 15% of my client base asks about it, and if we do anything it's a small allocation,” he said. “I tell my clients that they do give up something by going this route because of higher fees and lower performance.”

Similar to the early criticisms of screens applied to funds investing for religious values are the arguments still being made that excluding companies, and thereby shrinking the pool of potential investments, has to hurt investment performance.

But the more modern model — the one that has evolved over the past decade — involves a more holistic approach to evaluating companies that is less about excluding than it is about measuring and calculating the longer-term impacts of corporate actions and policies.

(Related: Socially-conscious investing gets a boost from the DOL fiduciary rule)

“Understanding how companies are impacted by ESG risks is important,” said Jessica Ground, global head of stewardship at Schroders Investment Management.

Even though Schroders only has about 10% of its $446 billion specifically allocated to ESG strategies, Ms. Ground said looking at companies through an ESG lens can identify all kinds of risks and opportunities.

“A lot of what I do is making sure that when we're investing, we're thinking about these risks, and how that impacts the valuation,” she said. “It's an added layer of research integration that we're applying, and it's really about improving investment decisions.”

The general idea, and the thing that is really taking shape across the investment landscape, is the notion that a company identified as being exposed to various legal or regulatory liabilities, is likely to see a negative impact at some point on its financial statements.


“We think the industry is evolving rapidly,” said Karina Funk, manager of the Brown Advisory Sustainable Growth Fund (BIAWX).

Since the start of the year, the fund is down 8.17%, which compares with an 8.55% decline for Morningstar's large-cap growth fund category.

“Profit versus the planet is not a tradeoff,” she added. “We only look at the intersection of the companies that are strong and are doing wonderful things for the environment and for society. Think about the solar industry, for example. Those companies are not fundamentally strong. There aren't millions of companies at the intersection, but those are the companies that deserve to be in our portfolio.”

David Sand, chief investment strategist at Community Capital Management, believes the ESG investing movement is going to catch some individuals and companies flat-footed and unprepared for where things are heading.

“I could imagine a time where what we call sustainable investing is just called investing, and investing without an adjective is the exception,” he said. “Ten or 20 years ago that would have sounded like a kooky thing to say.”

Community Capital specializes in bond portfolios that Mr. Sand described as “100% mission aligned.”

The flagship product is the CRA Qualified Investment Fund (CRATX), an intermediate-term bond fund that has essentially sworn off corporate bonds, due to strict ESG standards.

This year, through Feb. 24 the fund was up 1.88%, which compares to 1.67% for Morningstar's intermediate-term government bond fund category.

“I think, in the equity space, you're going to see the ESG specialization going away and you're going to see more ESG generalists,” Mr. Sand said. “ESG is just another component of risk management.”

To that end, Morningstar is folding ESG into its mutual fund and exchange-traded fund research. The new rating system that debuted last week will be based on the sustainability score of each fund's underlying holdings, said Jon Hale, head of sustainability research at Morningstar. The ESG scores will separate the funds in each investment category into five groups of best to worst.

“We expect that funds that have sustainability as part of their mandate will get the highest ratings,” Mr. Hale said.


It could be argued that once a company like Morningstar starts applying ESG ratings to all mutual fund and ETFs, the entire universe of funds will effectively become ESG funds. That is one way of looking at it. But a more accurate assessment might be that ESG criteria will become more widely used and better understood.

Ms. Ground of Schroders gives Morningstar credit for its efforts but admits her own portfolios might not always earn high scores in that system, which is something investors and financial advisers will need to understand.

“I can't promise that all my funds will look above average on that, because we're looking at things from a different direction, and sometimes, like a credit rating on a bond, the bond trader might have different views,” she said. “I hope fund managers don't just become complacent and be happy with a high score, because we know it's an ongoing process. I think it's the start of a conversation, not the final result.”


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