The Capitalists’ Guide to ESG

“Ten years from now, I don’t think we’ll still have a label for environmental, social, and governance (ESG) investing,” begins Jagdeep Bachher, CIO of the University of California (UC).“In the past—even for those called pioneers in this space—ESG investing had been about checking the boxes and filling in a scorecard: How much of your portfolio is earmarked for specific ESG strategies this quarter? Which security will you be excluding today? But now, we’re investing in an age where we cannot ignore what is happening with climate change and its risks. We have to look at how to embed ESG needs into the entire investment decision-making framework and evaluate that risk in a holistic way. And this is what we’ve begun doing at the University of California.”

Last September, UC announced it would actively gear its entire $91 billion retirement and endowment portfolio for climate change, focusing especially on solar energy projects. The university also vowed to invest $1 billion over five years into finding solutions for the mutating climate. It joined the United Nations-supported Principles for Responsible Investment, and promised to uphold them.

“We have learned that embracing ESG cannot be simply about one narrow strategy, like divestment,” Bachher continues. “It’s about going beyond: Reevaluating the way we make our investment decisions and implementing values that change our DNA and culture. It’s not enough to satisfy the sustainability police.”

However, the sustainability police are currently the loudest voices on the topic of ESG investing. Often in the shape of student groups and grassroots movements, they target institutions with demands that they divest from coal, oil, and gas holdings, dominating news headlines and occasionally administrative meetings. Groups like 350.org ask organizations to “immediately freeze any new investment in fossil fuel companies” and divest from direct ownership and commingled funds that include such ownerships within five years. The operation makes clear that what they’re pushing isn’t purely an economic strategy, but rather a political and moral act (at least in their view). These dimensions, however, can undermine investors’ ability to fulfill their fiduciary duties and maximize risk-adjusted returns. Hitting one’s investment target is hard enough with just one bottom line, many asset owners say, nevermind two or three. When student groups pushed Bachher last September—then very new into his role—to divest, he issued a statement saying, “the university is not in the business of taking the easy route.” Instead, he said reconstructing the investment framework would likely “be more effective over time.”

Since officially laying down the policy, UC has taken a hard look at its real assets portfolio, considering the general impact of macro events, according to the CIO. The investment office has also started conversations with a number of other institutions looking to take initiative and account for carbon risk in their portfolios. Now, Bachher says, the mission is leveraging that ESG lens into tangible and profitable market plays—a leap that’s stymied many an asset owner in the past.

“In the last 8 to 10 years, we have seen ESG investing gradually shift from a values-based strategy to actually creating financial value,” says Arti Prasad-Naidu, a responsible investment specialist at Australia’s Queensland Investment Corporation (QIC). “The evolution is clear: Responsible investment is moving away from just being a push from religious-based organizations screening stocks based on their ethical or moral values to now truly integrating and adding an extra layer of consideration for ESG factors. Investors now seek to make returns by doing good.”

But Prasad-Naidu warns that like most investment strategies, meaningful results demand patience. Those prepared to apply what she calls a “common-sense approach” over a long time horizon will, she says, spot risks they’d otherwise ignore. Speaking of ‘horizons’, an ESG-attuned investor might, for example, have dodged the catastrophic losses inflicted on BP shareholders following the Deepwater Horizon oil spill in 2010.

However, for asset owners with fiduciary responsibilities, the specter of weakened returns from an ESG-focused portfolio presents perhaps the largest hurdle to broad institutional uptake. Much like quantifying a portfolio’s carbon risk or ability to “do good,” it’s tricky to measure and benchmark ESG strategies’ performance. Metrics matter—and when it comes to sustainable investing, they tend to waver.

“What is clear is that there has been strong growth and interest in ESG strategies,” says Mamadou-Abou Sarr, Northern Trust’s global head of ESG. And he’s right. According to non-profit group Business for Social Responsibility, the demand and market for ESG-oriented products have grown tremendously in recent years. ESG-friendly assets grew from $5 trillion in 2007 to more than $32 trillion in 2012—or about 25% of the world’s financial holdings. eVestment data likewise reflects a mounting interest worldwide. But, Sarr cautions, “there still isn’t one definition of ESG, making it difficult to aggregate portfolios and performances to draw overarching conclusions.” Further complicating factors include the myriad time spans used for existing figures and the impact of the global financial crisis.

Even indices created to “measure” ESG-oriented portfolios lack robustness, Northern Trust argues. While most market players can agree about what counts as a mid-cap developed market stock, there are about as many definitions of ESG investing as there are proprietors of ESG-aligned products. For example, returns and risk for socially responsible US funds indexed by Bloomberg have largely aligned with broad market indices like the Russell 3000. But MSCI’s ESG indices for the world, North America and Europe, Australasia, and Far East outperformed all of their respective market cap-weighted index benchmarks.

While clear metrics on the strategy’s track record remain elusive, investors themselves overwhelmingly report no drag on performance. More than half (57%) of nearly 100 institutional investors believed ESG criteria had made a direct positive effect on their risk-adjusted returns, a recent survey by Mercer and alternatives specialist LGT Capital Partners found. Only 9% of respondents felt the orientation detracted from performance. Furthermore, LGT found more private equity and hedge fund managers had begun incorporating ESG factors due primarily to investor pressure.

“Just like a traditional strategy, some ESG-focused investments will do better than others,” says Mika Malone, managing principal at consultancy Meketa Investment Group. “It’s important to understand that there is still a cyclicality in performance when you implement ESG policies to your portfolio. And that there is no perfect way to create them.” Instead, she says, the key is to piece together two separate parts of the puzzle—to do good and to do well—which requires asset owners be crystal clear on their objectives. “It’s difficult for investors to address all three components of ESG,” she continues. “Try to separate your specific objective on the value-front of the investment objective first.” Then do your research. Malone advises searching out managers running strategies that have done well for peers in the past for reasons that remain relevant going forward.

The next five to ten years will be critical in the evolution of ESG strategies for institutional funds, says QIC’s Prasad-Naidu. “The world is changing, resources are being impacted, and investors need to change with it,” she says. The next step, according to UC’s Bachher, is rendering ESG risks as second nature in investors’ minds as interest rate or inflation risk. A policy declaring the adoption of ESG criteria isn’t enough, he says. Nor is box-checking by screening sin stocks or dumping whole sectors.

Out with the Birkenstocks; in with the benchmarks.