Understanding ESG Investing

Transcription

1 Understanding ESG Investing Answers to advisors and investors most pressing questions about ESG Sharon French, CIMA Head of Beta Solutions Executive Summary ESG investing is a method for evaluating how companies environmental, social and governance (ESG) practices may impact their performance. This approach to investing has become increasingly popular, spurred by shifting demographics, increased global climate and resource risks, regulatory changes, and an increased focus on ESG among asset owners. Recent years have brought an expanding array of metrics for evaluating ESG practices and that trend will likely continue. A number of studies have demonstrated that taking companies ESG practices into account may offer investment benefits, including an enhanced risk-return balance. Over the past several years, ESG investing has garnered considerable media attention and increased interest among investors. But many investors and even some advisors are still not exactly sure what ESG investing constitutes, and a lack of standardization in the terms and methodologies used with this type of investing only adds to the confusion. There are also doubts about whether ESG-focused portfolios can deliver strong returns, as many skeptics still believe that focusing on any non-economic attributes of a company can hinder performance. This paper offers a broad overview of ESG investing and seeks to answer some of advisors and investors most pressing questions and concerns about this approach to investing. What Is ESG? ESG investing is a type of sustainable investing, which is an umbrella term for investments that, while seeking positive returns, also consider and evaluate the long-term impact that business practices have on society, the environment, and the performance of the business itself. In addition to ESG investing, sustainable investing includes exclusionary screening, which is also known as socially responsible investing (SRI), and impact investing. While these terms are often used interchangeably, their approaches are actually quite distinct and it s important to keep in mind how they differ. Exhibit 1 outlines what each of these terms constitutes. Exhibit 1: The Three Types of Sustainable Investing Strategies Avoids Exposure Targets Outcome Not FDIC Insured May Lose Value Not Bank Guaranteed Definitions Examples Exclusionary Screening ESG Investing Impact Investing Excluding companies or sectors that aren t compatible with investors missions or values. Also known as SRI. Exclude an industry such as fossil fuels or a country such as Sudan. Adhere to Catholic values by screening out companies engaged in business of weapons, tobacco, alcohol, gambling, contraception, etc. Identifying data on companies ESG policies and practices and systematically incorporating these considerations into the investment process. Invest in companies with high ESG scores across sectors (a best-in-class approach). Overweight a portfolio with companies that have a low carbon footprint. Investing with the intention of generating a measurable, beneficial social or environmental impact along with a financial return. Target positive impacts on the environment by buying green bonds. Invest in a company delivering high-quality, low-cost health care to low-income populations and track the results.

2 OppenheimerFunds According to the US SIF Foundation, of the $40.3 trillion of total assets under professional management in the United States in 2016, $8.1 trillion is invested in ESG portfolios. That represents a 30% growth rate from 2014 when such assets totaled $6.57 trillion.¹ Exhibit 2. Exhibit 2: Growth of ESG Assets Is Accelerating Total U.S. Assets in ESG Portfolios U.S. ESG Growth $12 Assets ($) in Trillions ESG Incorporation Shareholder Resolution Overlapping Strategies Sources: MSCI. US SIF Foundation, November Overlapping assets shown as negative to avoid a double counting effect. Of these assets, $5.38 trillion is allocated among separate accounts and other non-specific vehicles primarily serving institutional investors. While the retail market is relatively small, it is also experiencing a rapid growth rate. In 2016, the total ESG assets of investment funds (mutual funds, variable annuities, ETFs, closed-end funds, alternatives) and other listed pooled products has risen to $2.6 trillion, which is more than double the $1.01 trillion that was tracked in 2012, and more than 10 times above the $202 billion of ESG assets that were held in The 475 mutual funds account for both the largest number of ESG funds and the greatest share of retail ESG fund assets under management at $1.72 trillion. Exhibit 3 Exhibit 3: Total Number of ESG Assets by Fund Type ESG Assets in Investment Vehicles (in billions $) $16.9 $3.5 $0.7 $206.3 Variable Annuities (16) ETFs (25) Closed-End Funds (3) $1,718.3 $651.7 Alternatives (413) Other Pooled Products (70) Mutual Funds (475) Source: US SIF Foundation, November

3 The Right Way to Invest Why Is ESG Investing Generating So Much Interest? Various types of sustainable investing, and SRI in particular, have been around for decades, but interest in these strategies, and ESG investing in particular, has increased significantly in recent years. A number of factors can explain why this topic has been garnering so much more attention. Millennial Investors and Women Have Particular Interest in Sustainable Investing. A number of studies have shown Millennials are very interested in sustainable investing, and interest is especially high among affluent Millennials. 67% of Millennials vs. 36% of Baby Boomers believe investments are a way to express social, political and environmental values. ² 90% of affluent Millennials vs. 76% of wealthy non-millennials said they were interested in realizing competitive returns from their investments, while also promoting positive social and environmental outcomes, according to a 2015 survey conducted by TIAA. 84% of ultra-high-net worth Millennials expressed an interest in SRI and impact investing, and 76% expressed interest in ESG investing, in a survey conducted in 2015 by OppenheimerFunds and Campden Research. This level of interest is particularly relevant given that $30 trillion in wealth will be transferred from Baby Boomers to their heirs, including the 90 million Millennials, over the next several decades.³ Studies have also found women are very interested in sustainable investing. A 2014 survey conducted by Morgan Stanley found women investors were two times more likely than men to consider investments that both deliver positive returns and make a positive impact. Again, that level of interest will become increasingly important, given that within the next 10 years 66% of the consumer wealth in the United States will be controlled by women. 4 Given the amount of assets that Millennials and women control, they will have considerable clout in driving the investment industry to focus more on ESG. Rising Environmental, Social and Corporate Governance Concerns Across the Globe It s been said that sustainable investing isn t about changing the world, it s about understanding how the world is changing. As almost every investor understands, in recent years we have seen a dramatic rise in disruptive weather patterns, droughts, and air pollution, to name just a few of the large-scale, global crises. Beyond the environmental concerns, social and corporate governance issues are also becoming ever more important. Populations around the world are aging. Some areas are being affected by mass migration and food and water shortages. Inadequate and undisclosed corporate governance standards have sometimes led to extensive corruption that brings significant harm to companies investors, employees, and consumers. For investors to determine which companies are best equipped to handle, and even potentially help resolve, any of these global challenges, it has become essential to have an effective way to evaluate their ESG practices. Sustainable investing isn t about changing the world, it s about understanding how the world is changing. 3

4 OppenheimerFunds ESG Investing Is Being Recognized by Government and Industry Organizations In the past few years, government and industry organizations have also changed their views toward ESG investing in ways that will greatly contribute to the growing interest in this approach to investing. In October 2015, the U.S. Department of Labor (DOL) clarified a previous communication that seemed to discourage retirement plans from using ESG investments. The DOL has issued new guidance that ESG considerations are proper components of the fiduciary s primary analysis of the economic merits of competing investment choices. With this development, retirement plans could begin to lead the way in the adoption of ESG investing in the U.S. market, and several are in the process of reviewing or have already adopted ESG policies and strategies to their investment platforms. 4 Other countries have gone one step further by requiring their pension plans to disclose whether ESG data are incorporated into their investment funds policies and procedures, 5 by integrating ESG principles into their mandatory investment framework, or outright banning controversial investments, as was the case with the Netherlands, which in 2014 prohibited public pension funds from investing in companies that manufacture cluster munitions. 6 In 2015, the United Nations Principles for Responsible Investment (PRI) began a three-year program to work with investors, asset managers and policymakers in different countries to promote international awareness of fiduciary responsibility and sustainable investing. As of April 2015, the PRI signatory base represented $59 trillion in assets under management, which represented a 29% year-over-year increase. That constitutes well over half of the world s institutional assets, a level of penetration that demonstrates these principles now have the potential to assert considerable influence on how the more than 1,400 signatories worldwide invest. 7 In 2016, the well-known fund rating service, Morningstar Inc., introduced its Sustainability Rating TM for mutual funds, to help investors gauge how well the companies in a fund s portfolio are managing ESG factors. This development only further strengthens the validity and acceptance of integrating ESG scores into investment decisions. Can Focusing on ESG Deliver Investment Benefits? Much of the lingering skepticism about sustainable investing stems from the difficulties some socially responsible investments had in delivering strong corporate financial performance. That contributed to the notion that focusing on anything beyond economic factors or traditional company fundamentals, such as earnings, would create portfolios that underperform. Research has been conducted to examine this question and historical evidence suggests that socially conscious and ESG-focused practices may contribute to investment returns. Companies with Strong ESG Practices Have Better Corporate Financial Performance Deutsche Bank examined 2,200 studies of sustainable investing and found positive correlations between strong ESG practices and corporate financial performance for companies in every region of the world. Those positive correlations held up across all the asset classes it examined equities, bonds, and REITs. If companies with good ESG practices have better corporate performance than firms with poor ESG practices, then it follows that investment portfolios that focus on companies with the best ESG practices may benefit from that enhanced corporate performance, compared with non-esg-focused portfolios. Researchers at the University of Oxford proved this thesis in a comprehensive study that combined the findings of 200 empirical ESG studies. The researchers concluded that companies with robust sustainability practices demonstrate better operational performance, and the beneficial impact of these practices was found to be stable over time. The research also showed a correlation between diligent sustainability practices and corporate financial performance. 8 4 The findings were as follows: 90% of the studies on the cost of capital showed that sound sustainability standards lower the cost of capital of companies. 88% of the research showed that solid ESG practices result in better operational performance of firms, which ultimately translates into cash flows.

5 The Right Way to Invest 80% of the studies showed that stock price performance of companies is positively influenced by good sustainability practices. In addition to better operational performance, companies with strong ESG practices have also exhibited lower risks. The University of Oxford study demonstrated that companies with higher sustainability scores not only have better operational performance and lower cost of debt and equity, but they can also be less risky. In an examination of mutual funds, Morningstar found a statistically significant relationship between funds with higher sustainability ratings and lower volatility. 9 Sustainable Funds May Potentially Outperform Traditional Funds The Morgan Stanley Institute for Sustainable Investing found, after reviewing performance data from 2008 to 2014 for 10,228 open-end mutual funds, that sustainable funds tend to exhibit slightly higher returns and lower volatility than their traditional counterparts, barring a few exceptions. 10 Building on their previous research that proved a link between sustainability efforts and financial performance, Calvert Investments and Harvard researchers demonstrated that systematic analysis of ESG data may increase shareholder value while mitigating risk. Their assertion is that capital markets are efficient because of the rich financial information available and therefore offer limited opportunities to realize excess returns or alpha. However, ESG issues are not widely understood or quickly incorporated into stock prices, thereby making for inefficient markets and creating an opportunity for investors to generate alpha. But the materiality of the ESG issues considered was a key factor. The study concluded that as long as investors can effectively identify ESG considerations that are materially important for a company and make investment decisions accordingly, they can uncover risks and opportunities that markets have not yet valued and that are not captured in conventional funds. 11 The potential for alpha generation is illustrated by the divergence of ESG investing styles shown in Exhibit 4. The green line represents the companies who rank among the top 10% for ESG factors deemed material for each company s industry and the black line represents the companies who rank among the bottom 10% for their industry s relevant ESG factors. To the extent that investors or portfolio managers can identify material factors and apply them to stock selection, they can add value through investing in top ESG-rated companies, which are more likely to perform better than companies with low ESG ratings. These findings clearly also suggests that managers who employ ESG evaluations may gain an edge over managers who do not conduct any ESG analysis. Exhibit 4 Exhibit 4: Applying Material ESG Factors to Traditional Stock Selection Growth of $1 Invested in March 1993 $ Top ESG Score Bottom ESG Score Mar 93 Dec 93 Sep 94 Jun 95 Mar 96 Dec 96 Sep 97 Jun 98 Mar 99 Dec 99 Sep 00 Jun 01 Mar 02 Dec 02 Sep 03 Jun 04 Mar 05 Dec 05 Sep 06 Jun 07 Mar 08 Dec 08 Sep 09 Jun 10 Mar 11 Dec 11 Sep 12 Jun 13 Mar 14 Dec 14 Source: Calvert Investments, The Calvert-Serafeim Series, June Past performance does not guarantee future results. 5

6 OppenheimerFunds What Has Changed About Sustainable Investing? Even with the evidence of the performance potential of sustainable investments, there may be some lingering skeptics. These skeptics may not realize just how much has changed and how much progress has been made with sustainable investing in recent years. The rise in the popularity of ESG investing has brought a substantial increase in the data available to evaluate companies ESG s practices. Just consider: More companies report: In 2011, only 20% of the S&P 500 companies published sustainability reports, according to the Governance & Accountability Institute. By 2015, 81% did. Companies are reporting on a broad array of issues, including their atmospheric emissions, energy and water consumption, labor and diversity standards, human rights practices, executive compensation linked to ESG performance and charitable contributions. Many companies are adhering to the Sustainability Reporting Guidelines developed by the non-profit organization, the Global Reporting Initiative. While multinational companies with global franchises were the first to adopt these guidelines, many mid-cap and smaller companies across a range of industries are adopting them as well, according to the Conference Board s 2015 Report of Sustainability Practices. More third-party sources are gathering data: Today a number of firms the most prominent of which are MSCI, Sustainalytics, Thomson Reuters and Bloomberg are all gathering and reporting data on companies ESG practices, and provide comprehensive ESG scoring on an ongoing basis. Companies Climate Performance Score (CDP) scores, which provide a measure of their climate change initiatives, are now available on Google Finance, thus adding to the pool of public data that investors have access to. Instead of simply screening by sector, the amount of readily available ESG data mean interested parties can assess companies individually leading to valuable information toward complexity and variation in ESG investing tactics. More analysts cover ESG: Firms are building out their ESG platforms as an integral part of their business and today, there are more analysts engaged in collecting and evaluating ESG data than ever before. Higher levels of engagement with ESG issues: Today, shareholders, proxy advisors, and asset managers are much more active in holding companies to higher ESG standards. Increasingly, shareholders don t want to simply be passive owners of stocks. Increasingly, they re voting with their assets to persuade companies to adhere to high ESG standards. With all of this additional data, investors have more detailed information they can use to evaluate companies, and asset managers find it much easier to construct ESG portfolios with effective screens, tilts or themes that capitalize on the richness of that data. How Are Companies ESG Practices Evaluated? The firms that evaluate companies ESG practices examine a broad range of issues and consider how prepared companies are to handle an ESG risk, how transparent they are in disclosing ESG-related issues, and how well they responded if they ever dealt with a high-profile ESG incident. The number of specific issues various ESG research firms will look at range typically from 60 to 140, with the inclusion or weighting of these factors varying according to the exposure a particular industry has to them. The analysis is both quantitative and qualitative, drawing on specific data points and analysts informed judgments. Following are examples of the issues taken into consideration for each component of ESG. Environmental With regard to environmental, the ESG evaluators look at issues like a firm s carbon intensity, which is a measure of the greenhouse gases a company emits from its business practices, in relation to its revenue. They will also examine how a company sources its raw materials, how much waste it produces in its operations, how waste is disposed of, and whether its product packaging is disposable. 6

7 The Right Way to Invest It is not only the avoidance of bad practices that matter. A company can also have a higher score if it makes positive ESG contributions with initiatives such as the use of clean technology or the construction of green buildings. Social On the social front, how companies deploy their human capital is critically important in the evaluation of their ESG practices. Companies labor management practices are assessed, as are the measures they take to ensure the health and safety of their workers. ESG analysts will also take into account the labor practices of the suppliers that companies use. The impact that companies products and services has on their customers matters as well. Companies who make low-quality products that put their customers at risk would have low social scores, while companies engaged in positive initiatives, such as delivering products that help improve nutrition for low-income populations or enhance health care for consumers in underserved regions would receive high social scores. Governance With regard to governance, ESG evaluations look at how well a company manages itself. Executive compensation is a key consideration, particularly with respect to where executive compensation falls relative to the company s industry, with lower scores given to firms whose executive compensation is excessive. A history of engagement in corrupt practices will bring down a governance score, while strong safeguards to support and encourage business ethics will raise a score. The rights of shareholders, and the protections provided for the interests of minority shareholders, are key considerations, as well. An Opportunity to Align Personal Values with Financial Goals For investors, ESG investing offers an opportunity to align their personal values with their financial goals, while benefiting from the potential that a focus on ESG has to generate returns and enhance the management of investment risks. Many of the previous hurdles to effectively managing an ESG-oriented portfolio are being cleared away. Data is being standardized and company disclosures on these matters are more reliable. More independent organizations support this effort, including the United Nations Principles of Responsible Investment, the Sustainability Accounting Standards Board, the Global Reporting Initiative and the CDP (formerly known as the Carbon Disclosure Project, but now a broader organization that helps companies measure and manage their environmental impact). ESG investing already has a strong presence in the institutional market, and investment innovations that begin with institutions often carry over to the retail market. We are seeing evidence of this trend playing out as more ESG funds and ETFs for retail investors are being introduced. There are now 500 ESG mutual funds and ETFs, totaling $1.72 trillion in assets. The growth in ESG portfolios for the retail market that we have seen in recent years is likely to continue. In October, OppenheimerFunds unveiled two new ESG ETFs, and Eaton Vance announced it will acquire Calvert Investment Management, which currently oversees $12 billion in responsible investments. The scale of the global environmental and social crises that call for better ESG practices at companies, the growing interest in these issues among investors, the increasingly rich ESG data and the evidence that suggests ESG focused portfolios may offer an opportunity to enhance a portfolio's risk-return profile, all lead to the same conclusion: ESG investing is here to stay and offers investors quite exciting investment prospects. 7

8 Sharon French, CIMA Executive Vice President, Head of Beta Solutions Sharon French leads the strategy, development and implementation of the firm s smart beta ETF products and solutions. In addition, she oversees the firm s Environmental, Social and Governance (ESG) efforts. She serves on the firm s Senior Leadership Team, governing the overall strategic direction of OppenheimerFunds. Sharon has held a variety of senior roles during her 30 years in financial services and joined OppenheimerFunds in 2016 from BNY Mellon, where she was Senior Strategic Advisor to the CEO and President of Investment Management, focusing on ETF and multi-asset business growth. Previously, she served as President of F-Squared Capital. Before that, she was Head of Private Client & Institutions at BlackRock for its ishares business. Sharon spent nearly a decade at AllianceBernstein and held prior roles at mpower, Smith Barney, and Chase Manhattan Bank. Sharon serves on the Board of Women in ETFs. She received a B.S. in Business Management from the University of Delaware, and earned her Certified Investment Management Analyst (CIMA ) designation from the University of Pennsylvania s Wharton School of Business. Visit Us oppenheimerfunds.com Call Us Follow Us 1. Source: US SIF Foundation s Overview of Sustainable, Responsible and Impact Investing in 2016, available at 2. Source: 2014 U.S. Trust Insights on Wealth and Worth Survey. 3. Source: Accenture: The Greater Wealth Transfer: Capitalizing on the Intergenerational Shift in Wealth, Source: CalPERS Adopts Environmental, Social, and Governance Strategic Plan, as of August 15, State Comptroller DiNapoli Positions New York Pension Fund For Low Carbon Future, as of December 4, Long Term Stewardship: A Pragmatic Approach for ESG Integration for Institutional Investment, North Carolina Department of the State Treasurer, as of September 21, Source: Pensions & Investments, January 19, Source: ESG: Becoming Mainstream. Institutional Investor, November 4, Source: Unpri.org, as of April Source: "From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance," University of Oxford and Arabesque Partners, September Source: Higher Sustainability Ratings Can Mean Lower Risk. Morningstar, as of October 13, Source: Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies, a white paper published in March 2015 by the Morgan Stanley Institute for Sustainable Investing. 11. Source: The Financial and Societal Benefits of ESG Integration: Focus on Materiality, Calvert-Serafeim Research Series, Calvert Investments, June Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. The stocks of companies with favorable ESG practices may underperform the stock market as a whole. These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are subject to change based on subsequent developments. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY OppenheimerFunds, Inc. All rights reserved. JL November 27, 2017