NEI looks at some of the lingering myths about responsible investment funds and what the research shows.
As the considerable challenges facing the world from an environmental, social and economic (ESG) perspective become increasingly clear, more and more investors want solutions that reflect their values and contribute to the changes they feel are important, in addition to growing their wealth. Nevertheless, uncertainty about the value and efficacy of investing with a purpose lingers.
A 2021 survey of investors by Canada’s Responsible Investment Association (RIA), for example, indicated that about 69% of respondents said they knew little to nothing about responsible investing (RI), while an RIA survey of advisors revealed that many overestimate their understanding of the topic.
Here are some of the common misconceptions around RI and what recent research has revealed:
MYTH #1: RI is a fad
Once viewed as a niche or “nice-to-have” addition to a traditional investment portfolio, the record inflows into responsible investment strategies in recent years show that sustainable investing with a broader purpose beyond wealth generation now represents a significant shift to the mainstream for many institutional and retail investors.
According to the Global Sustainable Investment Alliance, sustainable investment strategies expanded by 15% in two years to reach US$35.3 trillion in assets in 2020, accounting for about 36% of all professionally managed assets in major markets globally. Some of the strongest growth is occurring in Canada, where investment in sustainable investment strategies grew by nearly 62% during the same two-year period.
Several trends point to the fact that investing through an ESG lens is here to stay. Signatories to the UN-sponsored Principles for Responsible Investment (PRI), for example, continue to grow exponentially, while sustainability has become a baseline consideration for many institutional investors, including large public pension plans in Japan, Canada and the Netherlands, among others. And as retail investors and their financial advisors become increasingly aware of the benefits of RI, growth of the approach is expected to continue.
MYTH #2: Responsible investors sacrifice performance
It’s long been believed responsible investing strategies underperform their traditional peers, but a growing body of empirical evidence indicates that ESG investments tend to perform in line with —or even better than — comparable strategies over the longer term. Given a key component of ESG investing is managing risk for investors, it makes sense that companies taking a leadership role in tackling some of world’s biggest challenges in a rapidly evolving socio-economic and regulatory environment also perform well from a financial perspective.
In 2019 the Morgan Stanley Institute for Sustainable Investing published a study comparing the return and risk performance of ESG-focused mutual and exchange-traded funds (ETFs) against traditional counterparts. It found that that there is “no financial trade-off in the returns of sustainable funds compared to traditional funds, and they demonstrate lower downside risk.” Moreover, during periods of extreme volatility, the study found strong statistical evidence that sustainable funds are more stable.
While many investors will continue to invest in RI strategies based on their strong conviction to improve the world around them regardless of the results, others will be encouraged by research showing that they can also do well by doing good, contributing to the continued growth of the sector.
MYTH #3: RI strategies have limited investment options
Historically, socially responsible investing strategies were known for simply avoiding the “worst” areas of the market, such as illegal weapons or tobacco, and directing investment toward ESG leaders or socially progressive projects.
While exclusionary strategies still exist, responsible investing has evolved to encompass a wide variety of approaches such as investing in best-of-class operators or around certain socially or environmentally responsible themes. Some RI strategies will exclude whole industry sectors such as fossil fuels, for example, but others will attempt to have a positive impact by investing in fossil fuel producers and engaging with those companies to steer them towards more sustainable energy sources, or in others that champion transition technologies that bring cleaner sources of energy to the world.
The growth of the RI movement, meanwhile, is contributing to an expanded list of securities available for RI consideration. As ESG factors are increasingly integrated into the analysis of their value, companies are raising the bar on sustainability practices in order to attract capital. Depending on the goals of the mandate, responsible investors are including a wider range of asset classes, including public and private equities, corporate bonds and sovereign bonds into their strategies, as well as sustainability-linked bonds that lower the cost of borrowing if the issuer meets certain targets.
MYTH #4: Responsible investors pay significantly higher fees
Based on the additional resources needed to evaluate risks and opportunities based on ESG criteria, it’s often assumed that RI strategies are more expensive than traditionally managed funds. Certainly, some impact strategies and investments that incorporate corporate engagements and shareholder advocacy, may require higher management fees to support those strategies.
Elsewhere, however, more RI funds are benefiting from the economies of scale that come with the growth of the sector and can fulfill their prospectus requirements without charging a fee premium. Given the wide availability of ESG scoring data and third-party analysis, most RI funds are no longer investing in completely uncovered stocks or bonds. Rather, they can leverage existing security analysis and scoring tools to make informed investment decisions. At the same time, regulatory bodies are requiring increased disclosure around ESG considerations to assist investment managers in finding opportunities and managing risks.
MYTH #5: You can’t measure the true impact of RI
Concerns that companies and issuers may overstate their sustainability claims – also known as greenwashing – has kept many investors on the sidelines, unsure if they can trust that ESG investment strategies are having the intended positive impact. While due diligence will always be important, investors can take comfort in the fact that securities regulators are increasingly requiring companies to disclose more ESG information, lending credibility to the space. In Canada, the Canadian Securities Administrators has proposed mandatory climate-related disclosure requirements for public companies, while the U.S. Securities and Exchange Commission is considering a mandate for public companies to release consistent climate-related risk information.
Another difficult aspect of ESG investing is quantifying the “materiality” of sustainability initiatives on the results of the business. For example, it’s much easier for a company to provide data on its employee turnover rate than to assign a monetary value to the impact of that turnover on the business.
As sustainability becomes more important to investors and other stakeholders including employees, customers and partners, a growing body of research points to the ways ESG factors can enhance financial returns and reduce risk. Businesses that prioritize sustainable practices tend to be well managed, long-term thinkers and industry leaders. They are also well positioned to increase the value of their brand, improve efficiencies, benefit from pricing power, and enhance profit margins. A company that attempts to improve its environmental performance by reducing plastic packaging, for example, may initially face higher costs, but will ultimately be rewarded for that behaviour in the marketplace.