June 2016 From niche to mainstream: how ESG principles are reshaping investing today Leo M. Zerilli, CIMA Head of Investments John Hancock Investments As ESG standards become more uniform and as corporate performance along those metrics becomes more transparent and widely available, we believe demand for investment vehicles that incorporate ESG principles will only increase. Key takeaways Environmental, social, and governance (ESG) investing is an increasingly mainstream way of incorporating nonfinancial metrics into the investment decision-making process. ESG investing has evolved dramatically over the years, from a simple screening process that eliminated certain industries to one that seeks to identify companies that are leaders in sustainable and responsible business practices. ESG investing has reached a tipping point since its early days, so that broad ESG indexes today have kept pace with the broader market. The number of funds and assets dedicated to ESG-style investments has grown sharply in recent years, reflecting strong demand from a range of investors, especially among institutions, high net worth investors, younger investors, and women. Executive summary For decades, sustainable investing was considered a niche market, one that offered portfolios that excluded industries such as tobacco, firearms, alcohol, and gambling. The cost to investors of aligning their portfolios with their personal values was high, as these products often struggled to keep pace with traditional investment strategies. As ESG investing matured, however, that trade-off essentially disappeared: Today, many professional investors are using ESG metrics as a means to manage portfolio risk, identify quality management teams with sustainable business practices, and, in some cases, seek to positively influence corporate behavior.
A closer look at the history of ESG investing Sustainable investing has been around for centuries, tracing its roots back to faith-based investments. Today, it is one of the fastest-growing segments of the investment universe, with myriad ways for investors to align their portfolios with their personal values. While there are many labels used to describe this style of investing, the most encompassing is ESG investing, the three broad areas managers focus on when constructing portfolios of sustainable or socially responsible companies. ESG investing as we know it today started in 1971 with the launch of the first publicly available mutual fund in the United States to use nonfinancial criteria as well as traditional fundamental analysis in the investment decision-making process. The general goal of that fund, like many of its successors, was to make a positive impact on society and the environment while pursuing investment returns that were comparable to the broad market. ESG investing in the United States was something of a niche market until the early 2000s, when investors and asset managers began to acknowledge that ESG issues, which were typically not included in traditional financial analysis, had the potential to materially affect corporate performance over the long run and, therefore, returns to investors. Growth in recent years has been robust: Over the past two decades, ESG investing in the United States has grown from 55 funds to more than 900, representing more than $4 trillion in assets and a diversity of approaches. While the United States has been one of the fastest-growing regions in recent years, the rest of the world has recognized the value in ESG investing for some time. In 2014, global assets dedicated to sustainable investing totaled more than $21 trillion. 1 The U.S. ESG market is experiencing a rapid acceleration in funds and assets Investment funds incorporating ESG factors $5,000 4,306 4,000 Total net assets (in billions) 3,000 2,000 1,000 0 Year 12 96 154 136 151 179 202 1995 1997 1999 2001 2003 2005 2007 569 2010 1,013 2012 2014 Number of funds 55 144 168 181 200 201 260 493 720 925 Source: Report on US Sustainable, Responsible and Impact Investing Trends 2014, The Forum for Sustainable and Responsible Investment, 2015. Please note that ESG funds include mutual funds, variable annuity funds, closed-end funds, exchange-traded funds, alternative investment funds, and other pooled products, but exclude separate account vehicles and community investing institutions. Past performance does not guarantee future results. 2
June 2016 The evolution of the ESG investment process During the early days of ESG investing in the 1970s, portfolios were primarily built around exclusionary screens. Companies that engaged in questionable environmental practices or that had a detrimental impact on society tobacco companies or weapons manufacturers, for example were removed from a portfolio manager s investment universe. The companies that remained were screened and weighted against fundamental financial metrics in much the same way that a traditional portfolio would be constructed. Over the years, as ESG investing gained more of a foothold and pressure increased for corporations to be increasingly transparent about their social and environmental impact, asset managers began adding a second, positive screen to their investment processes. Rather than simply excluding companies that scored low on ESG metrics, managers were able to begin tilting portfolios in favor of companies that were performing well on ESG criteria. Increased transparency surrounding ESG metrics A kind of tipping point in ESG investing occurred in 2005 when the United Nations Environment Programme Finance Initiative (UNEP FI) developed a legal framework for the integration of ESG issues into the mainstream financial system. With more than 200 members globally, one of the key tenets of the UNEP FI is that it is not only permissible for investment companies to integrate ESG issues into investment analysis, but it is arguably their fiduciary duty to do so. Along those same lines, in 2010, researchers at the Initiative for Responsible Investment at Harvard University set out to develop and test a methodology for identifying material industry-specific ESG issues and their associated performance indicators. The strong positive reception to that research led to the creation of it is not only permissible for investment companies to integrate ESG issues into investment analysis, but it is arguably their fiduciary duty to do so. ESG investing deals with a wide range of issues Environmental issues Social issues Governance issues Climate change and carbon emissions Product safety Board composition Air and water pollution Data protection and privacy Audit committee structure Energy efficiency Gender and diversity Executive compensation Water scarcity Employee engagement Lobbying Waste management Supply chain management Political contributions Deforestation Labor standards Bribery Biodiversity Community relations Corruption Source: CFA Institute, 2015. 3
the independent nonprofit Sustainability Accounting Standards Board in 2011, which today is a leader in corporate sustainability reporting standards. Shareholder advocacy, public policy, and impact investing The evolution of ESG investing didn t stop with positive screening: Many ESG investors have moved beyond portfolio construction to leverage their position as stockholders in order to influence public policy and corporate behavior. There are a number of tools available within this kind of corporate engagement, including phone calls, written correspondence, in-person meetings, and site visits. By influencing legislation and regulation, asset managers can often influence positive change across entire industries. For example, the ESG investment industry was very active in promoting the Dodd-Frank regulations that addressed financial reform, and has also advocated for stronger environmental regulations, which has helped ensure that companies report greenhouse gas emissions and disclose risks related to climate change. Debunking myths about ESG investing Despite the rapid growth of ESG investing, there are a number of major misconceptions that have consistently surfaced. Myth #1: ESG investing is still a fringe approach While this may have been true 20 years ago when ESG investing had attracted only $12 billion in U.S. assets, the growth of the practice in recent years has firmly established ESG investment principles in the financial industry. 2 In fact, in a recent survey of investment professionals, 73% of investors consider ESG factors in their investment decisions. 3 Why are so many investment professionals integrating ESG factors into their company analysis? The top reason is because investors believe it helps them to identify and manage investment risks. In fact, a survey of investment professionals showed that only 7% of respondents said they look at ESG factors because regulation requires it. 3 Many ESG investors have moved beyond portfolio construction to leverage their position as stockholders in order to influence public policy and corporate behavior. Why do investment professionals consider ESG issues? Survey response Respondents (%) To help manage investment risks 63 Clients/investors demand it 44 ESG performance is a proxy for management quality 38 It s my fiduciary duty 37 To help identify investment opportunities 37 My firm derives reputational benefit 30 Regulation requires it 7 Other 5 Source: Environmental, Social, and Governance Issues in Investing, CFA Institute, 2015. 4
June 2016 By rewarding companies that score well on ESG issues or by engaging directly with companies through shareholder advocacy investors have helped shape and improve corporate behavior worldwide. Myth #2: ESG investors must sacrifice return to make positive change ESG investing has often been stigmatized by the assumption that investors are forced to concede returns to create a positive impact. The impression of assumed underperformance came from the early days of ESG investing and was, in general, well deserved. Investment strategies that used only negative screening to exclude companies or industries often sacrificed diversification to comply with their self-imposed limitations. The resulting portfolios may have been socially responsible, but they were also less diversified and carried higher risks. It s also true that ESG principles were generally less important to many corporate management teams than they are today. In the 1970s and 1980s, an ESG portfolio based on exclusionary screens would have had a relatively small investment universe to draw on. But this is not the case today. By rewarding companies that score well on ESG issues or by engaging directly with companies through shareholder advocacy investors have helped shape and improve corporate behavior worldwide. One example is the percentage of business executives who recognize sustainable practices as being important to their shareholders. This figure, which stood at just 22% in 2009, is now roughly 60%, according to a 2016 MIT study. 4 In fact, researchers at the University of Oxford analyzed 200 studies on the sustainability practices of companies across a broad range of industries and found that: 80% of the studies showed that the stock performance of companies is positively influenced by good sustainability practices 88% of the studies showed that strong ESG performance correlates with better operating performance of companies 90% of the studies on the cost of capital showed that sound sustainability standards lower companies cost 5 ESG returns have kept pace with the broad stock market Growth of $10,000 (2001 2015) $25,000 20,000 n S&P 500 Index n MSCI KLD 400 Social Index 15,000 10,000 5,000 2001 2003 2005 2007 2009 2011 2013 2015 Source: MSCI, Standard & Poor s, 2016. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The MSCI KLD 400 Social Index is a market-capitalization-weighted index of 400 U.S. securities that provides exposure to companies with outstanding ESG ratings and excludes companies whose products have negative social or environmental impacts. It is not possible to invest directly in an index. Past performance does not guarantee future results. 5
Myth #3: the market for ESG funds is small and insignificant Despite the growth of the ESG marketplace over the past decade, there continues to be a misconception that the type of investor interested in ESG strategies is somehow outside the mainstream, that ESG funds are catering to the same group that would label themselves as political or cultural activists. In reality, that stereotype couldn t be further from the truth. Institutional investors, including pension funds and insurance companies, have long been at the vanguard of incorporating ESG principles into their investment practices. According to US SIF, institutional investors in the United States now apply ESG criteria to investment decisions for aggregate assets of more than $4 trillion, which represents a 77% increase since 2012. 2 institutional investors in the United States now apply ESG criteria to investment decisions for aggregate assets of more than $4 trillion, which represents a 77% increase since 2012. Demand from individual investors also has the potential to be strong. According to one study, 86% of high net worth investors consider giving back an important or essential part of a life well lived. 6 When asked whether social or environmental impact is important to their investment decisions, 85% of millennials, 70% of Generation Xers, and 49% of baby boomers agreed that it was. This desire for affecting positive change was especially pronounced among women; a full 71% of those surveyed said the impact their investments had on the world mattered to them. The bottom line is that the demographics most interested in ESG principles are those that currently hold investable assets institutions and high net worth individuals or those that increasingly will women, Gen Xers, and millennials. Far from being a minority segment of the investment community, ESG strategies appeal directly to those institutions and individuals at the core of the investing world. ESG principles are important to a range of investors Percentage of respondents who agree that social and environmental issues are important to investment decisions 100% 80 60 40 49 By gender 71 85 By demographic 70 49 39 Nearly 6 in 10 investors consider a company s social and environmental impact important to their investment decisions. That figure rises dramatically among women and younger investors. 20 0 Male Female Millennials Generation X Baby boomers Age 69+ Source: 2015 U.S. Trust Insights on Wealth and Worth Survey, U.S. Trust, 2015. 6
June 2016 Conclusion From its humble beginnings some 40 years ago, ESG investing has experienced a groundswell of interest and support in the financial industry and among the investing public; today, it is an investment philosophy with a broad and rapidly growing appeal. As ESG standards become more uniform and as corporate performance along those metrics becomes more transparent and widely available, we believe demand for investment vehicles that incorporate ESG principles will only increase. Investors shouldn t have to choose between being value motivated or values motivated, and ESG funds offer a compelling way to pursue both of those important goals. 7
1 Global Sustainable Investment Review 2014, Global Sustainable Investment Alliance, 2014. 2 Report on US Sustainable, Responsible and Impact Investing Trends 2014, The Forum for Sustainable and Responsible Investment, 2015. 3 Environmental, Social, and Governance Issues in Investing, CFA Institute, October 2015. 4 Investing For a Sustainable Future, MIT Sloan Management Review in collaboration with The Boston Consulting Group, 2016. 5 From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, University of Oxford, Arabesque Partners, March 2015. 6 2015 U.S. Trust Insights on Wealth and Worth Survey, U.S. Trust, 2015. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. The information contained herein is based on sources believed to be reliable, but it is neither all inclusive nor guaranteed by John Hancock Investments. Diversification does not guarantee a profit or eliminate the risk of a loss. Large company stocks could fall out of favor. The stock prices of midsize and small companies can change more frequently and dramatically than those of large companies. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio. Hedging and other strategic transactions may increase volatility and result in losses if not successful. Illiquid securities may be difficult to sell at a price approximating their value. A fund s ESG policy could cause it to perform differently than similar funds that do not have such a policy. Please see each fund s prospectus for additional risks. A fund s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money. John Hancock Funds, LLC Member FINRA, SIPC 601 Congress Street Boston, MA 02210-2805 800-225-5291 jhinvestments.com NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. NOT INSURED BY ANY GOVERNMENT AGENCY. MF296404 ESGSRIWP 6/16