13 Sep 2019

These factors explain the spectacular rise of ESG investing

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For Marketing Purposes:

FOR QUALIFIED INVESTORS ONLY– This document is reserved and must be given in Switzerland exclusively to Qualified Investors as defined by the Swiss Collective Investment Scheme Act of 23 June 2006 (as amended from time to time, CISA).

2019 is the year that ‘ESG’ investing – adding environmental, social, and governance analysis into investment portfolios – hit the mainstream. Whether it’s looking at working conditions or gender diversity, reporting transparency or climate impact, more investors than ever are asking companies tough questions and challenging the ethos of “returns at any cost”.

And companies are responding too. Nearly 200 CEOs of major US firms including Apple, Walmart and Amazon recently stated that shareholder value should no longer be the number one priority, and are refocusing more attention to how they serve their employees, customers and suppliers, as well as the environment and the wider community.1

Today we kick off a series of short articles focusing on the role of ESG in portfolio construction. In this first instalment, we will cover the drivers of this growing shift towards ESG investing.

  • What’s behind ESG’s popularity? What are the trends in this area?
  • How do investors make ESG choices? Where do they get ESG data?
  • Does it make sense to invest in ESG using a passive approach?

What is driving the rise of ESG?

1. Recent financial crises

The global financial crisis of 2007-08, as well as company controversies such as the Volkswagen emissions scandal or BP Deepwater Horizon spill, have demonstrated to investors the risk of focusing on the short term and neglecting shareholder stewardship. In a number of high-profile cases, these scandals have significantly hit share prices and caused ripples throughout financial markets – incentivising investors to screen companies based on ESG practices in future.

2. More climate change awareness

More and more investors acknowledge the scale and potential impact of climate change. The global move towards reducing greenhouse gas emissions and increasing renewable energies will affect investments in all kinds of industries – not just energy. Food production, water provision, forestry and tourism will all be changed by this transition, and investors increasingly understand that supporting low-carbon projects and encouraging sustainable business will be necessary for long-term returns. Many are choosing to be proactive in this area by using ESG screens to direct capital towards change leaders.

3. Regulatory pressure

Professional investors are additionally being pushed by regulators to integrate ESG risk analysis and disclosure into the fiduciary investment process. Most of the world’s largest asset managers are now signatories to the United Nations’ Principles for Responsible Investment (PRI), representing assets under management of $86Trn.2 That’s a huge increase since a decade ago.

PRI Signatory growth2

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How can investors make ESG choices in portfolios?

Publicly available ESG information is becoming richer and more extensive, helping analysts assess the performance of companies according to ESG criteria.

For example, under the European Union’s Non-Financial Reporting Directive, from January 2017 all listed EU companies with more than 500 employees have had to disclose in their annual reports a variety of information relating to environmental, social and employee matters, respect for human rights, and corruption.

Specialised ESG databases run by governments, NGOs and academic institutions, as well as proprietary ESG scoring and ratings systems operated by extra-financial agencies, are also helping investors build a much more detailed picture of companies’ ESG performance.

Important recent political initiatives on sustainability are now part of many countries’ national legislation. These include the agreement reached at the 2015 Paris climate change conference, where 195 countries committed themselves to limit global warming to a maximum of 2 percent above pre-industrial levels.

All of this work is increasingly captured in indices, allowing investors to easily buy a basket of companies screened for ESG practices.

What is the best investment approach for ESG?

Although many ESG investors use active stock selection, a passive or index-based investment approach is equally well-suited for ESG. Sustainable indices can be used to express a variety of different investment approaches, including ESG integration, convictions on sustainability, or themes linked to the UN’s SDG framework.

Passive investment strategies have democratised access to the financial markets at a low cost, features that are entirely consistent with a focus on ESG goals. And both passive and ESG investment approaches are data-driven. The index company MSCI estimates that $180bn was allocated to its ESG indices between 2014 and Q2 2019.

Lyxor expects the role of financial indices in the area of sustainable investing to increase further. Benchmarks are now being used by policymakers as instruments to orient investor choices and to re-direct investment flows. And rather than just serving as a way to measure ESG risks, a new generation of ESG benchmarks is being developed to have a measurable impact, such as helping to meet climate transition goals under the Paris COP21 framework.

Read more about passive investing in ESG in our new report.

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Takeaways of part 1

  • ESG’s rise is driven both by bottom-up pressure from asset owners and by top-down policy initiatives.
  • More and more investors now focus on maximising ESG performance subject to risk-return constraints.
  • New ESG benchmarks are developed to have a measurable impact on key global goals.

In the next instalment…

We look at the question of flows:  How much demand is there for active or passive ESG funds? What do ETF flows tell us about ESG demand?

This article is for informative purposes only, and should not be taken as investment advice. Lyxor ETF does not in any way endorse or promote the companies mentioned in this article. Capital at risk. Please read our Risk Warning below.

1Source: Forbes, August 2019, Nearly 200 CEOs Say Shareholder Value Isn’t Everything.

2Source: UN PRI, as at end of June 2019.

Risk Warning

FOR QUALIFIED INVESTORS ONLY– This document is reserved and must be given in Switzerland exclusively to Qualified Investors as defined by the Swiss Collective Investment Scheme Act of 23 June 2006 (as amended from time to time, CISA).

This document has been provided by Lyxor International Asset Management that is solely responsible for its content.

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