Investors Are Starting to See the Positive Effect of ESG Investing

As the tide pulls some chief investment officers and asset owners toward improving corporate environmental, social, and governance (ESG) practices, there is strong evidence that ESG investing is now rewarded, especially in the Eurozone, according to a recent Amundi SA study. Investors are starting to see the positive effects of ESG investing on their returns.

Companies with high ESG scores in the Eurozone generated annualized returns of 6.6% from 2014-2017, compared to an annualized loss of 1.2% three years earlier. ESG investing in North America also saw positive returns, as top-rated ESG companies produced annualized returns of 3.3% during the same timeframe.

Until 2014, ESG best-in-class strategies provided neutral or slightly negative results, but when the study focused on shorter periods, it showed a positive selection effect on highly rated companies, sometimes combined with the underperformance of poorly rated stocks. According to the study, “The Eurozone and North America are particularly responsive to ESG integration, with a higher reward for governance and environmental pillars, respectively. Social began to be rewarded in 2016, and since then it is catching up.”

Martin Kremenstein, head of ETFs at Nuveen asset management ($970 billion assets under management), has also seen this surge, especially with small caps, “since quality is a key factor in deriving alpha.”

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In 2016, Nuveen launched ESG large cap value, large cap growth, midcap value, midcap growth, and small caps in the domestic space, and followed up with developed markets, emerging markets, and a core fixed income product in 2017.

Kremenstein is finding, “The alpha effect of ESG seems to be more cyclical in growth, but it seems to be consistent in value and small caps,” with his Nuveen ESG Small-Cap ETF (NUSC) in the top 6% of small cap core funds in Morningstar for the two years since launch.

For 2018, Nushares ESG Large-Cap Growth ETF (NULG) outperformed the Russell 1000 Growth by 230 basis points. The NUSC outperformed Russell 2000 by 174 basis points and the large cap actually outperformed by 395 basis points.

Screening Tricks

The trick is to start by ordering investments by sector, doing a controversy business screening (involvement in alcohol, tobacco, and firearms, etc.), scoring for the ESG material factors for that industry, applying the carbon screen, and finally optimizing weights, he says.

Ordering companies by sector ensures, for example, that Schlumberger is being compared with Valero. Facebook would be compared to Adobe and Microsoft (the latter two scored pretty well) and each would be given an ESG ranking relative to that sector.

During the second round, a company’s past response to controversy is assessed.

“A CEO’s misbehavior is one thing; a CEO’s misbehavior that reveals endemic structural and governance issues with the company is a much more significant event,” says Kremenstein.

Next, he scores companies on absolute carbon emissions, potential carbon emissions, and removes any with fossil fuel reserves. He then optimizes the weights of the sectors back to within 4% of the base non-ESG index, with 8% being the band for energy.

If this ESG screen was used to invest, the tanking of Equifax was likely missed because it revealed it wasn’t fixing the mounting problem that caused an earlier data breach in 2016 (of 430,000 names) before the big breach in 2017 (that could amount to 143 million Americans affected.) This same screen showed the waxing and waning of a Facebook investment due to the way it violated its privacy policies early on.

It begs the question: Shouldn’t investors know the ESG score of every company in their portfolios?

“There’s value that’s generated by employing the ESG metrics, because you’re essentially removing companies that have poor pollution and poor material resource management, companies that are wasteful, companies that have bad relationships with their investors, with their employees, and with regulators, and companies that have bad governance structures,” said Kremenstein.

Tags: Amundi SA, ESG, Eurozone, Martin Kremenstein

New Jersey Gov. Phil Murphy has vetoed a bill that would have imposed certain conditions on the investments of its retirement system and required due diligence in the selection of external managers.

The bill had been overwhelmingly approved by the state legislature as the New Jersey Senate passed it 26-12 with two senators not voting, while the state assembly passed it 67-6 with seven representatives not voting.

In his veto letter to the New Jersey state senate, Murphy said he rejected the bill because it was too broad and, as a result, “could jeopardize the overall health” of the state’s retirement systems.

“This bill creates broad proscriptions on the state’s investment practices that would be challenging for the Division [of Investment] to implement,” said Murphy. “The bill’s sweeping prohibition against any investments that could pose a ‘reputational risk’ to the state’s retirement systems, for example, could be interpreted to apply to a wide range of direct and indirect investments, and may be used to call into question investments that are objectively appropriate.”

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Murphy also said that he had been advised by the state’s treasury that the bill could undermine certain investment strategies that have been used to reduce fees and increase returns. As an example, he said the state’s Division of Investment has managed many of the state pension funds’ real estate investments through separate accounts rather than a commingled investment vehicle. He said the use of a separate account is expected to save the division approximately $39 million in fees over the life of the $300 million commitment.

“This bill could significantly reduce the division’s ability to take advantage of the savings opportunities available through this and similar investment structures,” wrote Murphy.

According to the text of the bill, the proposed legislation would have imposed conditions on domestic equity investments in the private real estate, private equity, and private infrastructure asset classes in which the Division of Investment has more than a 50% interest. The bill also imposed requirements related to the protection of public sector jobs and the selection of external managers.

The bill required external managers to be evaluated for their record of compliance with the policies, including any responsible contractor policies of public pension plans for which they served or have served as external managers. They would also have been required to disclose any instances of non-compliance with such policies, and to certify that they and their portfolio companies are not out of compliance with any such policies at the time of any proposed investment by the division.

Tags: Gov. Phil Murphy, New Jersey, Pension, Veto