Sustainable investing: ESG and beyond

A shifting paradigm

Global awareness of sustainability has never been higher—consumers, investors, corporations, policy-makers and non-governmental organizations are shifting their focus toward addressing environmental and social issues. The financial industry has also put a focus on sustainability, prompting the development of innovative sustainable investment strategies and calls to action for capital deployment towards the UN Sustainable Development Goals.

We believe that sustainability matters to all investors, as we discussed in our report “Sustainable investing: A private investor perspective” (dated 9 September 2020). Whether one’s focus is primarily on financial returns or on driving sustainable outcomes, consideration of environmental, social, and governance (ESG) factors can highlight tangible risks and present new investment opportunities. Systematically examining ESG topics can provide investment-relevant insight on evolving consumer dynamics, government spending, valuation, and financial performance.

This process of integrating material ESG information into fundamental investment analysis and due diligence processes has swiftly become a mainstream expectation for traditional investment management and is not a sustainable investment differentiator. Data from the Global Sustainable Investing Alliance supports this view: at the end of 2020, assets in investment strategies that integrate ESG topped USD 35tr, surpassing for the first time the assets in strategies applying exclusionary approaches. Further, Morningstar estimated that global sustainable fund assets totaled USD 4tr at the end of the third quarter of 2021. Definitions differ, but we expect estimates for both universes to continue climbing higher.

As traditional investment strategies increasingly consider ESG elements in their analysis, ESG integration alone will no longer be a differentiator. Instead, we expect to see continued focus on and differentiation between approaches which go beyond ESG, and explicitly focus on sustainability. It has been our long-standing view that sustainable investing goes beyond just ESG integration, but has sustainability as a key driver of the investment thesis. Investors following these strategies intentionally elevate the importance of ESG factors to overall portfolio construction and take the view that focusing on sustainability issues (in different ways across asset classes) is positively correlated with long-term financial performance. We do not see sustainable investing as a distinct asset class or a list of fund solutions; instead, it refers to an investment approach that can be applied in different ways across asset classes, from equities and bonds to alternative investments. The key differentiator from ‘conventional’ investing? Intentionality.

Sustainable investing coming to life

In our view, sustainable investing takes two fundamental approaches, which include various types of investment strategies:

Sustainability focus: where sustainability objectives represent a core element of investment strategy or instrument characteristics. This can be seen in investment strategies with an explicit focus on equity or debt of companies that are best-in-class and demonstrate leadership on ESG in how they operate; in investment strategies constructed with a focus on sustainability themes such as energy efficiency or healthcare; or bonds whose proceeds are earmarked to fund specific sustainability projects or initiatives, to name a few examples.

Impact investing: where investments demonstrate explicit intent to generate measurable and verifiable positive environmental and social impact alongside competitive financial returns. Examples include growth equity and venture capital strategies making investments in companies whose business models address specific sustainability challenges; equity and bond strategies with a focus centered on active engagement with public companies focused on sustainability outcomes; and bringing additional investment to multilateral development bank bonds focused on sustainable development activities.

These are just some examples of possible investment strategies, as the universe of such strategies continues to grow and evolve. We utilize the sustainability focus and impact investing approaches via their respective investment strategies as the building blocks of our sustainable asset allocations. Many of these strategies, like ESG leaders equities and bonds, or ESG engagement, require an assessment of companies’ operational performance on ESG topics. Still others like green bonds, multilateral development bank bonds or ESG thematic investing strategies have a sustainability objective but may not necessarily focus on assessing companies’ operational performance on ESG topics, but look at how sustainability factors shape the investment thesis for each security.

ESG integration, exclusions, and stewardship—the toolkit for investors

The relevance of sustainability issues for investment performance underscores the relevance of sustainability-related tools, which should be familiar to many investors and that can be applied to traditional or sustainable investment strategies. In our view, these are:

ESG integration: incorporation of material ESG information into bottom-up fundamental analysis of assets and investments, to ensure all relevant risk and performance factors are considered

Exclusions: removal of investments in certain activities, industries or specific companies, in order to minimize undesired exposures or to align portfolios with investors’ values and preferences
Stewardship: investor approaches to working with companies to encourage improved performance on governance and other topics; in the case of sustainability, stewardship is focused on ESG specific topics with room for improvement and often focused on contributions to SDG relevant topics

Investors can incorporate some or all of these three tools into individual investment strategies or overall portfolios, whether or not they have a particular focus on sustainability. For example, the portfolio manager of a disruptive technology public equity fund might integrate ESG factors to capture all relevant risk factors, which should contribute positively to risk-adjusted performance but does not in and of itself make the fund strategy explicitly sustainable. Or an individual investor might seek to exclude oil and gas companies from her US equity portfolio because they don’t align with her values, but again, absent a holistic sustainability thesis that drives the selection of all securities in her portfolio, this alone would not make her portfolio strategy inherently sustainable. And stewardship is a tool that any investor or fund strategy can employ to signal to companies key improvements that long-term investors want to see—traditional and sustainable investors alike use stewardship with portfolio companies.

The simple chart below is our attempt to represent how we see the various approaches and tools that can be utilized by investors with an interest in sustainability. Investors with a particular sustainability focus will likely want to emphasize investments in the sustainability-focused and impact investing buckets in order to achieve their SI objectives. Those who recognize the relevance of ESG for performance but don’t want to focus explicitly on sustainable exposures, will likely consider investments in the traditional bucket which have ESG considerations integrated into their process.

It is important to recognize, that investors have a choice as to how they want to bring sustainability into their investments. The universe of sustainable investing approaches continues to develop dynamically, and we will evolve our framework and portfolio approach accordingly as it does. Overall, we do see a clear shift in investor interest toward sustainability-focused and impact investments, as recognition of the long-term importance of social and environmental topics to overall economic and societal stability as well as corporate and financial performance.

All investment strategies are either intentionally sustainable, or have no sustainability intent or objectives.

ESG integration

Considering ESG information alongside financial metrics in the investment process

ESG exclusions

Avoiding investing in activities that may not be considered sustainable by the investor.

Stewardship/active ownership

Voting and engagement, across asset classes