ESG Investing is gathering pace like never before. And as an aware investor, you must be mindful of the ABC of the ESG!

ESG stands for environmental, social, and governance. The concept of ESG has been around for a long time, with its origins going back as far as 2005. UN Secretary-General Kofi Annan issued an ESG proposal submitted to the CEOs of the world’s leading financial institutions. Annan invited the CEOs to join an initiative, later known as Principles for Responsible Investment, to tighten the relationship between investors and the ESG issues.

Today, over these years, ESG has gradually evolved as a tool for the management to deliver outstanding returns to all stakeholders of a business. Companies all over the globe have been sensitized about the various aspects of ESG. Stock exchanges across the world seek to report on ESG principles. At the same time, ESG compliance opens up doors for global funding for businesses across the globe.

For a CEO, who cares about the long-term sustainability of the business, ESG is an opportunity to create value, drive profitability, and raise capital. ESG bonds have already made a mark in India, with Indian companies raising over $5 billion in the calendar year 2021 so far.

ESG assets are set to reach over $50 trillion by 2025. According to Bloomberg, that’s a third of total global assets under management.

Within the corporate environment, institutions are prioritizing their emphasis on ESG, moving beyond traditional corporate responsibility. Large financial institutions increasingly see ESG as corporate social responsibility.

The S&P Global Market Intelligence analyzed 26 ESG exchange-traded funds and mutual funds with more than $250 million in assets under management. It found that from March 5, 2020, the month that the World Health Organization officially declared COVID-19 a pandemic, to March 5, 2021, 19 of those funds performed better than the S&P 500. Those outperformers rose between 27.3% and 55% over that period. In comparison, the S&P 500 increased just 27.1%. An ethical investment portfolio can actually protect you from risk while allowing you to make a positive impact.  

The pandemic highlighted social and global inequality. It also pushed millions into poverty. The World Bank calculates that COVID-19 sent around 97 million people into poverty in 2020, and the negative impact continues to weigh. The pandemic has been such an existential crisis – such a stark reminder of the world’s fragility – that it has driven the world to confront the global threat of climate change more forcefully and to consider how, like the pandemic, it will alter lives across the globe.

At the same time, the creation of sustainable index investments has enabled a massive acceleration of capital towards companies better prepared to address ESG factors. Indeed, from January through November 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019.

Initially, ESG investments had a reputation for generating limited returns. But, today, the data suggests that there is an intrinsic relationship between a company’s ESG performance and long-term financial health. Traditional funds showed higher potential for loss during turbulent market years like 2008, 2009, 2015, and 2018, while sustainable funds posted strong performance. 

According to Bank of America, ESG investing could rise by $15 trillion to $20 trillion over the next decade because of changing demographics. As millennials, Gen-Z, and the generations to follow step into investor shoes, they are increasingly likely to select their portfolios based on companies that measure up to ESG metrics. The act of picking sustainable funds is reasonably intuitive due to respective companies being categorized by data providers. But despite this, it can be challenging to find a firm that fully subscribes to the ESG approach throughout. 

Some advisers suggest that it’s worth engaging with fund groups to see how companies deal with ESG issues in a bid to see whether they conform to a clear policy or not. Another positive comes from the fact that sustainable investing is growing in popularity today.

With significant increases in social and environmental awareness worldwide, shares from ESG companies, in particular, look set to ride this wave of interest and grow exponentially as a result. If this occurs, then investors will benefit from gaining some sizeable profits from green companies along the way.

Of course, investing in ESG shares comes with a few downsides, too. By far, the most significant drawback comes from the lack of diversity offered by ESG shares. Sadly, most companies that fit the criteria focus exclusively on large-cap stocks, limiting the prospect of diversification among investor portfolios. Thus, investors may find themselves starved of exposure to small-cap, mid-cap and non-US based companies. 

Another con is that some ESG mutual funds and ETFs and DIY investors develop strategies that entirely exclude specific industries, like tobacco and oil. While avoiding these industries is undoubtedly a good thing as far as the environmentally and socially conscious among us would agree, it only serves to enhance the risk of investors placing all their focus on very few industries – such as hydropower or electronic vehicles – which runs the risk of further diversification issues. 

For example, a heavily populated portfolio by wind-based energy suppliers is great in terms of adhering to sustainable investments. Still, investors could find themselves hamstrung if a windfarm is forced to close down or sanctions lower the global usage of wind power. 

So dear investors, it’s important to remember that socially responsible investing is a highly subjective matter, and there’s no guarantee that companies recognized as sustainable match your beliefs or investment goals.

With this in mind, it’s essential to conduct your research before buying shares or funds. Look for companies that match your ambitions and beliefs, and the act of investing in them will be its reward.

With the rising sensitivity towards the environment and social issues, it would be prudent to grab a bite in the ESG pie in your investment portfolios. ESG investing is likely to have a robust future and are expected to beat the index returns in the near term.

 Best Regards

 
Dr. Tarunika Jain Agarwal Ph.D.

Alpha Research