Every World Environment Day, humanity comes together to celebrate the beauty and pricelessness of our planet’s ecosystems and environment, in several possible ways. Some of us pledge to use a little less plastic, some of us actually start turning off our lights and faucets when we’re not using them, and some of us create ingenious works of art in appreciation of our planet. But what do you get when you cross World Environment Day with us investment geeks here at Liquide? You get a deep dive into the fascinating world of ESG and green investing!
The Growth Spurt
You’d be forgiven for scratching your head at how suddenly ESG investing came to dominate markets. ESG investing and green finance entered mainstream financial discourse in 2006, when the United Nations released its Principles for Responsible Investments (PRI), its set of guidelines on how to incorporate ESG principles into corporate decision-making and strategy. The PRI came to have over 2000 signatories, and is widely considered to be the official reference point for all things ESG.
The real acceleration began around 2017-2018, as the world began to recognize the severity of the consequences of issues such as man-made climate change, and understood how it’s up to everyone to act and make a difference, not just governments. To this end, several investors and asset managers began making more and more significant investments in a wide variety of environment-friendly companies, and companies that worked to mitigate any harm that they might cause through their actions. Meanwhile, as the covid-19 pandemic rolled in and legions of new retail investors began looking for good ways to save their money and invest it in a way that was aligned with their values, interest in ESG investing skyrocketed.
The numbers speak volumes. According to NASDAQ’s research, by the end of the first quarter of 2021, global ESG-specific investing amounted to nearly $2 trillion. JP Morgan Asset Management reported that worldwide, over $500 billion flowed into ESG-integrated funds in 2021, which contributed to a 55% growth in assets under management in these products over the previous year. Further, going by pandemic-era trends, by some estimates, the overall amount invested in sustainable investment funds globally could rise to a whopping $50 trillion over the next two decades.
How do these investments perform?
Obviously, going by just the sheer magnitude of these investments, they’re a very popular trend to be on. But us investors tend to care mostly about one thing above all: how much money are we making? So, let’s take a quick look at how these investments do, shall we?
The pandemic era that we live in today, beginning in 2020, gives us a great deal of variance in how markets overall have performed, making it a good starting point for us to truly measure how ESG investments actually measure up in any way that the financial winds blow.
Put simply, the still relatively new ESG investments scene offers us a bit of a mixed picture on whether this philosophy is the real deal, and on its fundamental resilience. In the first year of the pandemic, between 2020 and 2021, many large ESG funds outperformed the S&P500 by a significant margin. S&P Global Market Intelligence analyzed 26 ESG ETFs and mutual funds managing over $250 million in assets between March 5, 2020 (the date that covid-19 was declared a pandemic) and March 5, 2021. Of those 26, 19 outperformed the broader S&P500, returning between 27.3% and 55% over that year, compared to the still-respectable 27.1% returned by the S&P500. Naturally, this may seem to suggest that those funds are great investments, and sure enough, many investors piled right into many of them in that year.
Here’s where the situation gets a little trickier. While several ESG funds seem to have done much better in the famous bull run that we enjoyed around the world between 2020 and 2021, the adversity we’ve seen since the start of 2022 has certainly hit them hard. While the S&P500 is down 17.3% since the start of the year, the ESG index measuring several ESG funds’ performance in aggregate is down 18.7%. Clearly, this isn’t an ideal position to be in to be regarded as a stellar investment. But does that mean that ESG investing is down for the count, and that it shouldn’t be taken seriously? We’re not so sure.
The positives, and why ESG matters
Claiming that the damage borne by several ESG names, relative to the rest of the market this year, makes them bad investments, might be a little misguided and hasty. There are still sound reasons why this area matters.
- Demand is being led by investors. Any investment philosophy that works in a bottom-up manner is worth paying attention to, and given markets’ demographic trends, it’s very clear that this trend is one that’s here to stay, in a good way. Overwhelming majorities of around 87% of polled Millennials (people born between 1981 and 1996) and over 94% of polled adult Gen Zers (people born between 1996 and 2012) believe that companies have an obligation to address environmental and social issues, and these are investors willing to act on this belief. Substantial majorities of investors across all age ranges think that this type of sustainable impact investing is a valuable tool to effect change, and would, in fact, do more if they could directly monitor the impact that their money has on company strategy. With shareholders caring so much about what their investments are actually doing, and with a marked increase in financial awareness and literacy among younger investors, it would certainly seem that any dip in ESG investments is likelier to be a short-term phenomenon than an indicator of real malaise in the philosophy.
- Improving technology is a great enabling device here. Technology is helping make these ESG products easier to spot and analyze, and several ESG products also contain a significant proportion of tech/growth stocks which have the power to drive real innovation in the world. In fact, one could even possibly look at this and infer that the slump in ESG investing since the beginning of this year is in line with the broader panic gripping several growth stocks, meaning the slump isn’t really ESG-specific. Overall, though, this point means that investors aren’t just being offered more tools to make sounder judgments about their sometimes-risky ESG investments, but they’re also being put in a better position to have their money be genuinely impactful, which is really the goal in all of this, isn’t it?
- These investments may have governments on their side, as far as regulatory risks are concerned. We don’t want to downplay the very real phenomenon of misleading/phony greenwashing in markets today (which we’ll talk more about in a second), but even so, chances are that if you’re investing in an ESG name of repute, you’re investing in something that’s on the right side of the sustainability conversation. Many of these environment-friendly companies are likely to avoid facing substantial penalties or business model risks as a result. Needless to say, that’s something any investor, long-term or short-term, likes to hear!
- The transition to overall sustainability is creating new risks and opportunities. In spite of all the turmoil in energy markets and short-term swings in relatively dirty fossil fuels’ markets, one thing is clear: the imperative to transition away from them will force long-term market trajectories to favor sustainability. This investment philosophy tracks this very paradigm shift, and is a key reason why it’s worth keeping an eye on for the long term.
… Not so fast, though.
Like any investment, it’s important to be clear-eyed about the risks and challenges involved. And we’d like to be clear: there’s valid concerns surrounding ESG investments that we’d be remiss to not address.
- Several ESG investments sacrifice good financial performance, without offering much in return. We’ve already hinted at the beating that several ESG stocks have taken this year, but arguably, that could still be excused if they were at least offering improved non-fiduciary sustainability benefits to their genuinely concerned shareholders. But that might not have come to pass. Researchers at Columbia University and the London School of Economics compared ESG records for US companies in 147 ESG funds and 2428 non-ESG portfolios and found that the ESG portfolios’ companies also tended to fare poorer on labor and environmental rule compliance than the non-ESG portfolios’ investments. Even more concerningly, companies that were added to ESG portfolios didn’t really improve on their compliance by a statistically significant margin. These results were backed up by other studies too, meaning that there might be a problematic discrepancy between what investors think they’re investing in and what they’re actually investing in, which could damage long-term trust. That wouldn’t bode well for ESG investing as a whole, and is certainly a challenge that must be overcome quickly.
- Many companies may actually be touting ESG principles duplicitously as a cover for poor performance. Recent studies seem to find that several managers in companies that fail to meet analysts’ earnings expectations end up making a big deal about their commitment to ESG principles, while several managers in companies that met or exceeded earnings expectations don’t talk much about ESG at all. Now, to be sure, some of these results may be due to coincidences of some kind, but the results themselves are not reassuring. It could very well mean that fund managers in ESG funds might be investing in companies that perform poorly and deliberately mislead potential investors about their ESG commitments, which could again damage trust in ESG quite badly.
- Greenwashing is still a real phenomenon, and could hold back truly effective ESG investments. Many companies’ misleading claims about environmental friendliness could be working to reduce investors’ willingness to explicitly embrace ESG investing as a philosophy, since demographic studies also show that younger investors care more deeply about where their money’s actually going now, than ever before. Ultimately, misleading claims about commitments to environmental friendliness could end up meaning that investors choose to ignore ESG criteria as a metric for making their investments altogether, which would damage the segment’s prospects for the future.
The overall takeaway
Now more than ever, as humanity struggles to come to terms with the climate change that we have collectively caused and exacerbated, every single penny invested in a cause that could make a true difference, matters. Ultimately, that’s what ESG investing is really about, and for all the challenges posed to its viability, those real, practical imperatives will ensure that the criteria that drive that philosophy will grow to matter more and more in the years to come.
We believe that any investment requires sound analysis of the fundamental pros and cons that add or detract from its real value, and that is obviously something that every investor must do in the ESG realm too. That said, we recognize and commend the urge that investors increasingly have to put their money where their mouths are, and invest in line with the values they hold dear.
This World Environment Day, we salute every investor who works to make our planet a better place for every one of its inhabitants, and we admire the growth and potential that this philosophy demonstrates. Because companies and investments may come and go, but the one thing that stays constant is the number of Earths we have: one. Let’s all pledge to do our part as responsible investors and human beings to protect that precious, single Earth that we’ve got today. Happy World Environment Day!