These trends have propelled the rise of socially responsible investments (SRI), or ESG investing. An SRI strategy considers a company’s environmental, social and governance factors before choosing to invest in it. Retail and institutional investors alike are embracing the approach. A recent report from the Global Sustainable Investment Review found sustainable investment has grown by 15 percent in the past two years and by 55 percent in the past four years. Additionally, more than 2,250 money managers who oversee a combined US $80 trillion in assets have signed on to the United Nations-backed Principles for Responsible Investment (PRI).
Many private equity firms are now incorporating an ESG-centred approach into their allocation decisions for both performance benefits and risk management.
The advantages of socially responsible investing
While capital markets are often volatile, companies that take proactive steps to reduce risks in their business are usually stronger positioned to weather storms.
Environmental, social and governance factors have become part of the risk profile for companies today. Extreme weather events caused by climate change can damage critical infrastructure and temporarily halt the flow of goods and services. Compliance lapses can lead to significant regulatory fines. Human rights violations in one link of a company's supply chain can lead to significant reputational damage.
Fund managers now must be acutely aware of these sorts of risks when making buying decisions. An ESG-informed approach to investing helps fund managers keep risk management at the forefront of consideration. Through a socially responsible investment lens, financial institutions may shift their thinking and gather a broader, more diverse set of data points to evaluate companies. While fund managers will continue to look at dividend history, year-over-year revenue growth and other key financial performance indicators, factoring ESG into their considerations can be extremely valuable for reducing risk within the portfolio. Previous research has found ESG investments often correlate with lower market volatility and that some of the best-performing stocks also have some of the highest ESG ratings.
Along with more effective risk management, ESG provides another benefit for companies and their investors: strong market performance. A growing body of research over the last decade has shown these investments often perform well. One study found that socially responsible investments outperformed their benchmarks 63 percent of the time and that socially responsible equity funds met or surpassed the performance of traditional equity funds 65 percent of the time. A separate study from Harvard Business School found companies that more effectively addressed their direct sustainability risks had 9 percent higher financial returns than companies that didn’t focus on this area. In mid-2020, the global value of ESG-driven assets reached nearly US $41 trillion, and some ESG-focused indexes even outperformed other indexes last year during the heat of the pandemic. Sustainable funds outperformed traditional funds by 4.3 percentage points in 2020, according to research by Morgan Stanley.
Socially responsible investing offers opportunity to fund managers beyond just social benefit — funds can still do well, and potentially even better, by investing in companies that are doing good in society.
Shaping a socially responsible investment strategy
In recent years, financial regulators have moved to increase transparency and the accuracy of financial disclosures as investors acquire more ESG assets. The EU’s Sustainable Finance Disclosure Regulation (SFDR) is a prime example of ESG-driven regulatory change. The Task Force on Climate-Related Disclosures (TCFD) has also led efforts to create global ESG standards and a regulatory framework for climate-related financial reporting. Some financial software providers now offer tools to help investors assess companies’ ESG risk.
In the absence of a standardised global framework, ESG disclosures are primarily voluntary and self-reported. Much of the related data can be inconsistent and opaque, making it difficult for institutions to understand every material ESG risk a company may face or evaluate existing portfolio companies.
As the disclosure and reporting process evolves and becomes more consistent across jurisdictions, fund managers will have more data points to make more sound buying decisions as they construct portfolios. In the meantime, buy-side firms can take steps to integrate more ESG analysis into their research and proactively seek out information related to ESG scores to reduce their organization's downside risk as they select potential financial assets.
Firms also can increase socially responsible investments within their portfolio by reconsidering investments in industries that present a clear and persistent ESG risk. Additionally, fund managers can focus on growing sectors like renewable energy or companies bringing an innovative approach to traditional industries like manufacturing. Another approach is to focus on companies with the highest ESG scores within a firm’s target industry sectors or verticals.
Whatever strategy an institution or fund employs, it’s important to develop a data infrastructure to enable informed ESG analysis that can be applied across jurisdictions and sectors. This is a critical step to developing a sound portfolio of socially responsible investments.
The importance of environmental, social and governance factors will continue to grow in the markets. Taking an ESG-informed approach to investments will enable private equity firms to reduce material risks in their portfolio, prepare for increased regulations down the line and potentially achieve better returns.
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