ESG Investing: Why It’s Important to Institutional Investors

By: Rakesh Uthamchand, CFA, CIPM & Christopher Holmes, CAIA
May 19, 2021

Some investors who are very conscious of non-financial risks to their portfolios such as climate change – and wish to manage
and measure these risks – have already begun to allocate to their beliefs. Because climate change and social consciousness
have risen to the forefront of the minds of many, institutional investors should step up their game to focus on, and incorporate, innovative ESG strategies into their portfolios. 

ESG Investing: Your Money, Your Values
What is ESG investing? At its core, ESG is an approach that incorporates Environmental, Social, and Governance factors into an investment strategy. Other terms associated with ESG investing include values-based investing, sustainable investing, impact investing, responsible investing, socially responsible investing, socially conscious investing, “green” investing, and ethical investing. Each of these terms has its own nuanced meaning, which can vary according to individual perspectives.

Although the industry does not have agreed-upon definitions, these investing approaches generally share a dual mandate: achieving competitive investment returns while expressing the investor’s values. In fact, the lack of standard industry definitions may reflect the broad array of possible approaches that can be used to align an investor’s portfolio with their beliefs. The commonly listed ESG factors and subsequent approaches that can be incorporated into an investment strategy are generally classified as follows: 

Environmental: carbon emissions, pollution and other waste, natural resource usage, energy efficiency, sustainability initiatives
Social: Human rights, workforce safety and health, workforce diversity, equal opportunity, privacy and data security, community initiatives
Governance: Board independence, board diversity, shareholder rights, executive compensation, ethics policies and history

Typically, when investors think of an ESG approach, they associate it with stock strategies. However, corporate bonds, municipal bonds, and other asset classes can also be managed through an ESG approach. Generally, in this first of two articles on this topic, we’ll discuss ESG investing as it relates to corporate issuers. 

ESG Investing
 

Prevalence of ESG Investing

What the Factors Represent
The ESG factors classified above represent non-financial indicators of a corporation’s commitment to sustainable practices and good corporate citizenship. ESG investing seeks to satisfy the desire of many investors to invest in good corporate citizens and is based on the concept that environmental, social, and governance factors can also have financial relevance.

A common way to incorporate these factors into an investment strategy is to evaluate a company’s history and current commitment to some or all of these factors, then weigh that evidence along with traditional investment metrics when making decisions for a portfolio.

For example, if an asset manager is evaluating two stocks for a portfolio, each with a similarly favorable profile from a financial standpoint, the stock of a company whose board is well diversified, has an exemplary record in its employment practices, is committed to sustainable environmental practices, and avoids ESG controversies may be preferred over the other stock if the second company has a poor record in those areas.

ESG factors can be given varying levels of emphasis in an investment strategy. At one end of the continuum are traditional investing strategies that do not incorporate ESG factors. Instead, all emphasis is placed on traditional fundamental and valuation factors. At the other end are strategies that use ESG factor screening as the primary or sole rationale for including a company in the portfolio. The latter strategies can be described as “pure play” ESG approaches or “impact” investing.

How ESG Investing Emerged
While ESG investing has experienced a meteoric increase in attention during recent years, its roots go back decades. Beginning as early as the 1970s, socially conscious investors developed an approach known as “Socially Responsible Investing (SRI).” This approach:

  • Is exclusionary and involves the screening of stocks to exclude companies operating in “sin” industries (e.g., gambling, alcohol, tobacco, nuclear weapons, etc.) from a portfolio.
  • Can also include screening based on Catholic values, Sharia law, and other institutional frameworks.
  • Allows individual investors to customize their SRI portfolios based on the specific industries they wish to avoid supporting.

Traditional SRI has become more sophisticated over the years. With its enhanced abilities to avoid owners or subsidiaries of offending companies (and their distributors) and the ability to exclude with greater levels of specificity, many believe SRI represents a first-generation solution that has been eclipsed by ESG investing.

In the past, traditional SRI has been criticized as potentially leading to undiversified portfolios if an investor has an exclusion factor list that’s too broad. On the other hand, we believe:

  • SRI portfolios can be properly diversified through investor education and guidance that helps the client emphasize only the exclusionary factors that are of highest importance to them.
  • SRI’s exclusionary approach plays a unique role in the overall sustainable investing landscape.

At the same time, we also believe that traditional SRI provides only part of the total solution that investors now desire. Traditional SRI does not address the operating philosophies and practices of all companies — it merely excludes companies whose revenues are tied to certain industries.

The emergence of ESG investing allows investors to include companies across all industries who show that they are committed to the best practices of good corporate citizens (and avoid companies who do not). This “inclusionary” approach differentiates ESG from its predecessor, SRI, and allows investors to tilt their portfolios towards the leading companies on the issues that matter to them. It is also worth noting that, due to the inclusionary nature of ESG, the number of factors that can be incorporated into a portfolio without sacrificing diversification is greater than traditional SRI.

ESG Investing Enters the Mainstream
In addition to the compelling growth statistics in both global and U.S. ESG assets, the number of investment vehicles now available to would-be investors has grown. By the end of 2020, the number of mutual funds and ETFs that screen or incorporate ESG/SRI factors into their investments grew to 392, up 30% from 2019.³ (Morningstar)

Another striking indicator that ESG investing has entered the mainstream is reflected in the signatories to the United Nations Principles of Responsible Investment (PRI). This set of six principles was developed to provide a global standard for responsible investing as it relates to ESG factors.

Signatories must publicly commit to adopt and implement the principles where they are consistent with the signatory’s fiduciary responsibilities and report on their ESG investing activities. In 2020, more than 3,000 PRI signatories, including asset managers, consultants, intermediaries, institutional and other investors, represented assets under management of more than $100 trillion.4 (United Nations)

Is ESG Investing a Fad?
We don’t believe so. Intuitively, ESG factors can provide a framework for assessing some forms of non-financial risk, so it is not altogether surprising that many asset managers have embraced the PRI. Just as trends like cable cord-cutting, organic products and energy-efficient vehicles have proven to be much more than fads, we believe ESG investing is here to stay.

Surveys of investors and investment managers provide some of the reasons behind our belief about its staying power:

  • In a survey of U.S. individual investors, 85% said they would be interested in sustainable investing.5 (Morgan Stanley/ISI)
  • Investors commonly pursue ESG investing based on a desire to have a positive impact on the world but may also wish to reduce risk or avoid companies with legal issues, negative publicity, or reputational damage.6 (Bernstein)
  • The Forum for Sustainable and Responsible Investment found the top reasons asset managers incorporate ESG factors into their strategies include client demand (85%), mission or values (83%), risk reduction and management (81%), social benefit (79%), and fiduciary duty (64%).7 (US SIF)
  • In a survey of senior investment professionals, 63% responded that use of ESG information in investment decisions is material to performance, while 33% said it is an ethical responsibility.8 (CFA Institute)


As we said earlier, these trends don’t just impact stocks. ESG factors are being assessed in fixed income markets as well. According to PIMCO, outstanding issues of “green” bonds have expanded at an annual growth rate of 60% since 2015 to over $1 trillion in 2020.9 (PIMCO)

Many investors have come to the same conclusion. ESG is not a fad. For those who have not yet assessed how ESG investing might be used to reflect your organization’s values in your portfolio, we encourage you to think about the topics discussed in this article and reach out to your Commerce Trust Company Institutional Advisor.

What’s Ahead
In part two of this series, we’ll discuss whether ESG investing requires investors to sacrifice returns and look at the growing trends in the ESG landscape. Contact your Commerce Trust Company Institutional Advisor for more information regarding ESG investing.

¹Azoth Analytics, “Global Environmental, Social & Governance (ESG) Market Analysis by Investor (Retail, Institutional), Fund, Sector, Region and Country (2020 Edition): Market Insights, COVID-19 Impact, Competition and Forecast to 2025,” published December 2020, https://www.marketresearch.com/Azoth-Analytics-v4068/Global-Environmental-Social-Governance-ESG-13918813/
²General source for information and works cited: Commerce Trust Company Research Group, “ESG (Environmental, Social & Governance) Investing,” Commerce Trust Company, 2020
³Morningstar, “Sustainable Funds U.S. Landscape Report,” published February 10, 2021
4United Nations, “PRI Annual Report 2020,” referenced March 31, 2020
https://www.unpri.org/annual-report-2020/how-we-work/building-our-effectiveness/enhance-our-global-footprint#:~:text=The collective AUM represented by,investors and 337 service providers
5Morgan Stanley/ISI, “Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice,” published September 2019 https://www.morganstanley.com/content/dam/msdotcom/infographics/sustainable-investing/Sustainable_Signals_Individual_Investor_White_Paper_Final.pdf
6Bernstein, “Sustainable Investing: Don’t let ESG scores hijack your portfolio,” published 2018
7Commerce Trust Company Research Group, “ESG (Environmental, Social & Governance) Investing: Seeking to Do Well by Doing Good, 2020.
8CFA Institute, “ESG Investing Moves to the Mainstream,” Financial Analysts Journal, Third Quarter 2018
9PIMCO, “Understanding Green, Social and Sustainability Bonds,” referenced September 31, 2020
https://www.pimco.com/en-us/resources/education/understanding-green-social-and-sustainability-bonds

The opinions and other information in the commentary are provided as of May 7, 2021. This summary is intended to provide general information only and may be of value to the reader and audience.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed, and is subject to change.
Past performance is no guarantee of future results.
Diversification does not guarantee a profit or protect against all risk. This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such.
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Commerce Trust Company is a division of Commerce Bank.


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ABOUT THE AUTHOR

Rakesh Uthamchand, CFA® Assistant Vice President, Investment Analyst Commerce Trust Company 
Rakesh is an investment analyst for Commerce Trust Company. His primary responsibilities include research and quantitative analysis for selection of third-party managers offered in client portfolios, manager combinations, asset allocation studies, and institutional client studies.

Prior to joining Commerce in 2011, Rakesh was an investment analyst, where he was involved in manager research and analysis.

Rakesh has a Bachelor of Commerce degree from University of Madras in Chennai, India, and a Master of Business Administration degree from Missouri State University. Additionally, he holds the Chartered Financial Analyst® designation and is a member of both CFA Institute and CFA Society of St. Louis."

ABOUT THE AUTHOR

Chris Holmes Investment Analyst Commerce Trust Company 
Chris is an investment analyst for Commerce Trust Company, responsible for manager due diligence covering passive and smart-beta equity, tax-exempt fixed income, and sustainable investment managers. Chris joined Commerce Trust in 2019 after working as an intern at Argent Capital Management on the small-cap equity team.

Chris holds a Master of Science in finance degree from Lindenwood University as well as the Chartered Alternative Investment Analyst designation. He is also a member of the CAIA Association and a 2021 Level II candidate in the Chartered Financial Analyst program.