Over the past decade, interest in environmental, social, and governance (ESG) investing has grown dramatically. Investor inquiries about sustainable and ESG strategies have overtaken inquiries about more traditional investment options. At year-end 2020, the Morningstar platform offered more than 400 sustainable investment solutions. This number quickly grew to 437 by the second quarter of 2021. Compare that to a decade ago, when there were only a handful of options available.
Google searches. Interest in sustainability is well illustrated by Figure 1. It shows the popularity of Google searches for the term “ESG” from 2004 through 2021. The data shows a significant increase in these searches over the past few years. In 2022, we expect this to continue. Skepticism about ESG investments will continue to give way to acceptance and a greater understanding of the benefits these products can provide to investors.
Figure 1. Google Searches for the Term “ESG”
Source: Google Trends
Risks and return. The recent trends show that investors are ready to tackle climate challenges. Many individuals are beginning to realize that inaction will lead to systemic risks. Habitat decline, social division, and inequality pose significant risks to long-term portfolio returns. These issues lie at the heart of ESG investing. If we fail to address them, the risks will continue to compound. The likely result will be a volatile investment environment.
Money talks. Corporate management is taking note of recent investor trends. Most companies listed on the S&P 500 are making sustainability a key component of their public relations campaigns. In 2012, only 20 percent of S&P 500 companies produced sustainability reports. This statistic rose to 92 percent in 2021. The current trend reflects investor influences on business practices and corporate stewardship. Investments continue to flow toward areas that include engagement, proxy voting, and strategic divestment.
Individuals will have an increasing influence on corporate behavior in the years ahead. This trend also means there will be a greater alignment of stakeholder values. Previously, investors may have been more passive. Now, they are starting to challenge the corporate decision-making process. This trend is likely to continue throughout 2022. As a result, the industry may see an increase in disclosure requirements, investor scrutiny, and calls for action.
Greenwashing worries. There has been an unfortunate consequence of the strong ESG interest in recent years. Some organizations have attempted to brand themselves as “green” or “sustainably oriented” without making meaningful changes to their business practices. “Greenwashing” is the term used to describe this unprincipled approach.
Some investment companies use deceptive advertising claiming that their products and policies are environmentally friendly or sustainable. In reality, they have not taken meaningful action toward protecting the environment but instead have simply changed the language in their prospectuses. Observant investors have become aware of this practice, however, viewing firms that misrepresent their products as tarnished.
Firms that provide ESG ratings are making it more difficult for greenwashing to take place. The recent introduction of “commitment-level” ratings is evidence of this shift. Morningstar’s ESG Commitment Level evaluation relies on quantitative analysis. The firm’s research analysts look at the extent to which asset managers weigh ESG factors to make investment choices. This process puts more power in the hands of investors. The ESG scores also put more responsibility on asset managers. To operate in the ESG sector, asset managers must make sustainable investment choices.
In 2022, Commonwealth anticipates further standardization of ESG scoring systems in the industry. The result should be an improvement in data quality and reporting.
2022 and beyond. Strong evidence suggests that the interest in ESG products and solutions is just getting started. On the investor side, an estimated $73 trillion wealth transfer is set to occur over the next 25 years. Much of this wealth will fall into the hands of two demographics: women and millennials. Both groups have a keen interest in sustainable investing. In the future, their significant capital is likely to be repositioned toward ESG sectors.
Recently, 26 nations collaborated at the United Nations Climate Change Conference. Their leaders met to discuss action to attain global net-zero emissions and to keep the Earth’s warming to no more than 1.5 degrees Celsius. Each nation was asked to curtail coal use and deforestation, increase use of electric vehicles, and encourage investment in renewable energy. The conference let the world know that companies working toward a carbon-neutral environment will have opportunities to gain value. In contrast, companies that hold on to an unsustainable economy may lose brand loyalty, market share, and, ultimately, share price.
An ESG investing framework is well-suited for the economy of the future. It lends itself to uncovering potential return opportunities while also mitigating risks. ESG investors gain insight into nontraditional investment criteria that include environmental policy, workplace environment, and business relationships. Investors should consider how ESG investments fit into their portfolio allocations. They should also research whether their portfolio managers use ESG strategies. This path can help guide us toward a more sustainable future.
Disclosures: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Diversification does not assure a profit or protect against loss in declining markets. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. Emerging market investments involve higher risks than investments from developed countries, as well as increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners.
Investments are subject to risk, including the loss of principal. Environmental, social, and governance (ESG) criteria are a set of non-financial principles and standards used to evaluate potential investments. The incorporation of ESG principles provides a qualitative assessment that can factor heavily into the security selection process. The investment’s socially responsible focus may limit the investment options available to the investor. Past performance is no guarantee of future results.
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