22 Jul 2020

What the pandemic could mean for ESG investing

ESG Investing and Coronavirus
Florent deixonne

In this week’s Q&A with Florent Deixonne, Head of Sustainable & Responsible Investments at Lyxor Asset Management, we examine the impact of the COVID-19 crisis on sustainable investing. While it’s too early to jump to conclusions, ESG investments held up remarkably well during the sharp equity sell-off in March, demonstrating investors’ long-term commitment to sustainable exposures.

What overall impact will the coronavirus crisis have on ESG investments?

It’s still too early to know for sure how COVID-19 will affect the ESG market, but we certainly believe that it could be a catalyst for further growth.

First of all, this crisis has really focused minds on how well companies are run, from their contingency planning to the resilience of revenue streams. More and more investors (and non-investors) are now asking questions about the sustainability of business models and how better governance relates to long-term performance.

As the global economy moves towards recovery, we believe the “S” or social aspect of “ESG” could shine, with the focus on creating a more sustainable model for the future. As part of that, we may see increased pressure on issuers and governments that fell short during the crisis, and increased investment in those that succeeded.

We already saw this play out in fund flows. ESG funds in Europe held up remarkably well during the crisis. When investors urgently reduced their equity exposure in March, they largely did it by selling massive amounts of traditional broad-based index funds – usually weighted by market capitalisation rather than ESG ratings – while leaving ESG allocations as they were or even adding to them. This makes sense in that ESG allocations are usually part of more stable pockets of portfolios than other equity exposures, which is consistent with the long-term nature of a sustainable investment approach.

YTD cumulated Net New Assets for ESG and non-ESG ETFs in Europe (M€)

ESG flows chart

Chart source: Lyxor International Asset Management, as at 16/07/2020.

Finally, there may be investors who had previously decided to increase their ESG allocation but stayed on hold. If so, given some of the recent equity outflows, they may have bigger pools of capital to redeploy in the coming months and years. With all that’s happened, investors may move forward with a new perspective on some of the investment risks addressed by ESG funds. We believe this may lead to a long-term reallocation of capital and further growth in the ESG market. 

Will COVID-19 bring a change in emphasis between the three pillars of ESG?

Very possibly. COVID-19 has already been an unprecedented stress test of corporate social responsibility. I mentioned the “S” of “ESG“ shining a moment ago: by this I mean the ‘social value chain’, from employee protection to customer support, supply-chain management, and privacy concerns.

We can really see this increased emphasis playing out in the increase of COVID-19-related social controversies negatively affecting companies’ performance and reputation. Think about the number of news stories on inadequate protective gear for staff across different industries, weak policies or processes for consumer protection, misleading or misguided information on the pandemic, questions about data management and privacy rights, and so on.

Several socially-focused initiatives have appeared since the crisis began, such as the investor’s statement organised by Domini Impact Investments, the Interfaith Centre on Corporate Responsibility and the New York City Comptroller’s Office.1 This letter, which called on companies to help workers with paid holidays, health and safety measures and employment guarantees, was endorsed by investors representing over 9.2 trillion USD in assets under management.1 The United Nations Principles for Responsible Investment (UN PRI) have put in place a specific workshop with investors.2 The European Leverage Finance Association (ELFA) has produced a set of Reporting Best Practice Guidelines to support discussions between investors and company management during this period.3 We expect these kinds of initiatives to continue.

What are the main challenges in socially responsible investing?

The first challenge for effective socially-responsible investing is having good-quality ESG and climate data. At Lyxor, we have partnerships with some of the most advanced data providers (e.g. MSCI, the Climate Bonds Initiative, Sustainalytics) and we pride ourselves on having teams with strong financial engineering backgrounds who can do great work with the data from these partnerships. That why we’ve been able to build cutting-edge systems to help investors assess the impact of their portfolios in terms of ESG and climate risks.

Aside from the data aspect, the second big challenge, especially in light of the new EU regulations,4 will be the industry’s move in 2020 towards the “portfolio temperature” disclosure. Soon it will be possible to calculate the implicit temperature-increase scenarios for all the major known reference market indices (e.g. CAC 40, Euro STOXX 50, S&P 500, MSCI Europe…etc) and see immediately if a portfolio or benchmark is aligned (or not) with the Paris Agreement goals.5

Even if the intellectual methodology behind this subject is highly complex, associating an investment portfolio with a thermometer will be a concept of powerful simplicity, one that can be understood by everyone in the world and which we believe will become a de facto benchmark for future investors.

The nasty surprise waiting for market participants is that all the major equity benchmarks currently display scenarios of a temperature increase of 4 to 5 degrees, which by all scientific evidence is a disaster scenario in the making. The temperature impact of a portfolio will be a key input when setting portfolios on a low-carbon trajectory, which we think is the most effective strategy for managing transition risks for a financial player and also a relevant investment strategy to maximise the profitability of its portfolio in the medium term at a given level of risk.

How can ESG investors benefit from a passive approach?

There are plenty of benefits to taking a passive approach in ESG. First – and I alluded to this earlier – thanks to improvements in data quality, indices today can be built to reflect all sorts of climate and ESG policies, then make them accessible to investors at a low cost. Innovations in this area include selective screens that filter out, as an example, companies that consume or extract high amounts of thermal coal. They include the implementation of specific values such as gender equality, or stock selection based on carbon ratings, or alignment with the UN’s Sustainable Development Goals (SDGs).

Overall, better data means better indices and more ways to invest with an index-based approach in a transparent, low-cost and rules-based way – all important considerations for investors looking to generate sustainable performance through time.

Second, passive vehicles are extremely transparent. In our case, we share our proprietary method for ESG and carbon footprint analysis in our ETFs, allowing investors to monitor and measure the portfolio carbon footprint. We can share ESG ratings breakdown of companies, their exposure to positive and negative ratings trends, their business activities, the portfolio exposure to ESG controversies, UN Global Compact Controversies and transition risks, carbon risk management, the exposure to issuers offering environmental solutions, and the revenue exposure to environmental solutions which contribute to SDGs.

All this information is easily accessible through the product pages of our public website, meaning that any investor in our ETFs has this key information at their fingertips. ETFs and index funds also invest in publicly-listed assets rather than private, and as listed assets have higher liquidity than unlisted ones, an index investor can mobilise larger amounts of capital and make it work towards their goals.

And finally, good passive managers really have an active voice, setting up voting policies like an active manager. These policies and voting records are public and the manager is accountable to fund holders. In our case, Lyxor’s shareholder engagement policy involves a direct dialogue with companies to communicate expectations, for example with respect to governance. This shows that it is possible to encourage sustainable business practice with index investing – if that investment is with a responsible ‘active’ passive manager.

Where do you see ESG ETFs in five years’ time?

In our view, allocation to ESG ETFs is not a trend, it’s a transformation. The only question for us is how quickly this transformation will play out. In Europe, ESG ETFs are still less than 5% of total assets – yet they accounted for close to 17% of net flows last year.6 2020 has been much more volatile so far, but ESG is still the only segment of equities with positive inflows, and over 20% of all flows to fixed income.6

ESG ETFs were extraordinarily resilient in March during the height of the COVID-19 crisis, showing no signs of inflection even as the global market dramatically sold off. Overall, the crisis has validated investors’ choice to reallocate to ESG, because most ESG ETFs have shown significant outperformance during the period.6 That outperformance could attract new investors, which we think could accelerate the transformation.

Looking at the next few years, several factors could support a widespread conversion to ESG ETFs: first, the growing conviction that the index-based approach is not only consistent with sustainable investing but could be very well adapted to it; second, the sheer variety of indices spanning all investment philosophies, and all levels of ESG intensity versus diversification and tracking error targets; and finally, new segments opening up such as climate-transition ETFs, whose usefulness will be emphasised by the European climate benchmark regulation that’s coming up.4

Taking all of this into account, we believe ESG ETFs to represent closer to at least 20% of total assets in five years’ time – more than quadruple their current share.

4 https://ec.europa.eu/info/publications/sustainable-financeteg-climate-benchmarks-and-disclosures_en
5 https://unfccc.int/process-and-meetings/the-parisagreement/the-paris-agreement
6 Source: Lyxor International Asset Management. Data as at 25/05/2020. ESG ETF inflows in 2019 were €17bn, and
total assets under management reached €102bn. Past performance is not a reliable indicator of future results.

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