Raising The Bar For ESG Investing Expectations

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By Linda Giuliano

For years, many investors assumed that choosing environmental, social and governance [ESG] investing came with a cost - a performance shortfall. Based on our recent survey, that picture has changed.

In the 1990s and early 2000s, most investors believed that choosing responsible investing required them to pass up some amount of performance. In fact, this concern was so common that the word performance was mentioned in one-third of all responsible investing news articles published from 1982 to 2009. That's more than the references to any other term.*

In just a few short years, as ESG investing has gained more traction, there's been a noticeable shift in performance expectations for this approach.

Most Investors Expect Similar Or Better Returns From ESG

Today, the notion that investors have to settle for less with ESG returns seems to have all but disappeared. We surveyed more than 60 North American institutional asset allocators, and the responses clearly showed that most investors no longer think they'll need to trade off competitive performance when choosing ESG investing.

Nearly 70% of institutional investors we surveyed said they expect similar returns from ESG portfolios as from traditional portfolios (Display 1). These were professionals from retirement plans, endowments and foundations and other gatekeepers who collectively handle roughly $500 billion in assets. Even more surprising was that quite a few investors have raised the bar for ESG: among the other 30% of respondents, almost one quarter expected returns to improve.

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What's behind investors' evolving attitudes toward the performance implications of ESG investing? They seem to go hand-in-hand with a shift in the way ESG factors are implemented in portfolios.

When responsible investing first arrived, it was implemented mainly through negative screening. In this approach, an investment universe is whittled down by removing companies that are misaligned with an investor's moral and ethical perspective. Because this approach excludes certain types of investments - such as tobacco companies or weapons manufacturers - investors worried about its negative impact on performance.

According to our survey, negative screening is giving way to more holistic approaches such as integration. With an integrated ESG approach, investors explicitly consider ESG factors in research, integrating the expected economic impact into fundamental analysis. This process helps inform investment decisions.

ESG Integration Is Taking Hold

Among the investors we surveyed that had a dedicated ESG allocation, integration was by far the most common approach. And when we asked them to look ahead toward the next one to three years, they said they expected ESG integration to be even more widely adopted.

Our research aligns with the findings of some global industry studies. For instance, in its second Global Sustainable Investment Review (from 2014, the most recent available), the Global Sustainable Investment Alliance (GISA) cited ESG integration as one of the fastest-growing implementation strategies (Display 2). The growth in ESG integration was second only to that of sustainability-themed investing.

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Impact Investing Is Maturing And Gaining Momentum

The shift toward ESG integration is promising, but we think the potential for impact investing may be even more compelling. Impact investing targets a specific social and/or environmental goal across both public/private equity and debt markets to fund specific projects in underserved geographies or new technologies.

According to GISA, investors put just over $100 billion into impact/community investing globally in 2014. That's a relatively low base compared with other strategies, but impact investing clearly seems to be gathering momentum. In the 2016 Annual Impact Investor Survey by the Global Impact Investing Network (GIIN), 70% of respondents planned to undertake more of these deals in 2016; almost 60% expected to commit more capital.

What's driving this trend? Impact investing is maturing on several fronts, including the ability to research and evaluate products and performance.

Last year, investment advisor Cambridge Associates and GIIN unveiled the Impact Investing Benchmark, a broad measure of the financial performance of private-equity and venture-capital impact investing funds. The benchmark captured in numbers what impact investors already seem to know - there's no need to sacrifice returns. GIIN's survey respondents backed this up: nearly 90% cited financial performance that was in line with, or better than, they expected.

ESG has clearly come a long way, leading many investors to take a second look - and change their expectations. Innovations in the field have put the performance debate to rest - and are attracting a whole new generation of responsible investors.

*Gunther Capelle-Blancard and Stéphanie Monjon, "Socially Responsible Investing: It Takes more than Words." Centre d'Études Prospectives et d'Informations Internationales (CEPII), WP No 2010-15.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.