Ever it as mere window-dressing, sneering that the

 

Ever since
responsible investing’s inception, cynics have dismissed it as mere
window-dressing, sneering that the fad belongs on 5th Avenue and not
Wall Street. In 2008, when Hyatt Hotels heiress, Liesel Pritzker Simmons, asked
her financial advisors about “impact investing,” the bankers were aghast—halfheartedly
offering to cut out tobacco companies from her portfolio.1
Unsatisfied, she fired her financial advisors and set up her own impact
investing family office.2.

While not every investor has a $500 million inheritance to invest sustainably, responsible
investing’s transition to the mainstream has made environmental, social, and
governance (ESG) investing more accessible and more attractive. And, contrary
to what the critics claim, ESG investing is here to stay. A vast array of forces bolsters ESG’s claim
to the spotlight: both in the U.S. and abroad, top-down and bottom-up
strategies are implemented with young people and women facilitating the growth and
the future of responsible investing.

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            In
many countries, ethically-minded individual investors, like Mrs. Pritzker
Simmons, are the ones who drive demand for equally ethically-minded investment
products. However, Japan stands apart as an exception to the trend. The
Government Pension Investment Fund (GPIF) is the catalyst responsible investing
needed in Japan (its sustainable-investment balance lags behind Europe and
America).3
The GPIF has announced a management-driven
sustainable investment strategy, committing 3% of its holdings to socially
responsible assets this year alone, with a future goal of allocating 10% of its
assets to ESG funds, as well as calling for sustainable investment funds to
manage its foreign equity investments.4
They have also signed the UN’s Principles for Responsible Investment5—a
voluntary initiative that has amassed 1300+ signatories with $60 trillion in
assets.6

            Governments
and international organizations have recognized the need for responsible
investing and have responded with an array of solutions across the entire
world. The OECD is conducting research on ESG investing; the EU has multiple
initiatives in place, while countries all across Europe have implemented policy
tools on a national level, from forcing disinvestment in the arms and munitions
industry in Belgium, to legally requiring annual reports on corporate social
responsibility in Norway.7
Asian countries like Hong Kong, India, Japan, Vietnam, and Thailand are deploying
an arsenal of legislation to ensure the incentives of companies are in line
with environmental, social, and governance goals.8

            Perhaps
not surprisingly, millennials and women are the ones driving the demand for ESG
investing. 78% of the youngest generation (more than any before) and 62% of
women across the board (compared to 49% of men) consider ESG in investment
decisions.9
And while the causes these investors take up are many and varied, an undeniable
shift in the need for ESG investing has breathed a new air of urgency into financial
institutions and their investors alike.

Reassuringly, the
growth that sustainable investing has shown since its modest roots is being
buttressed by influential firms like Goldman Sachs and BlackRock committing a
growing amount of money to ESG investing. In the past two years alone,
BlackRock has created a new “Impact” division, Goldman Sachs purchased an impact-investment
firm, Imprint Capital, and other companies like Bain Capital have followed
suit.10
It is impossible to ignore the impact that these financial giants have brought
to sustainable investing. Goldman’s $7 billion commitment may be a tiny slice
of their AUM pie, it dwarfs the total investments of old-hand impact funds like
LeapFrog ($1
billion). Moreover, the entry of these notoriously unsentimental institutional
investors broadcasts a clear message about impact investing: it is profitable.

And just how is
impact investing profitable? That is a problematic and multi-faceted question. While
some practitioners still believe that the primary (and negative) impact is reducing
diversification benefits, that is a mistaken belief on two counts. Firstly,
impact investing should not be equated with simply negative screening, and
negative screening itself should not be dismissed offhand simply as deleterious
to portfolio construction.11
On the contrary, many investors believe that negative screening can reduce
portfolio risk and earn positive excess returns.12

ESG information
can be implemented to track different relevant qualitative effects, for example,
companies with promising ESG data receive laxer penalties if wrongdoing does
surface—a “halo effect”.13
Similarly, many investors agree that ESG information can inform them about
future regulatory and litigation risk.14
Arabesque, an sustainable investing quant fund, had dropped Volkswagen from
their portfolio due to low ESG scores long before the actual emissions scandal
came out.15

Beyond the broad
reputational and regulatory qualities of ESG data, there are multiple ways to
implement ESG data into the investment process including integrating into
valuation or portfolio optimization models, as well as using the information to
construct screening tools. For equity valuation, one of the ways to incorporate
ESG information is to adjust the discount rate with companies scoring poorly
having a higher risk profile and vice versa.16
Of course, every integration method presents its own challenges: here it is
difficult to gauge how large the adjustment should be (25 bps? 50?).17
Also, the investor runs the risk of double counting the risk—for example, if it
is already accounted for in a higher company beta.18
A more precise way could be to adjust the future cash flows of the company,
forcing the investor to directly translate ESG factors into financial
performance by honing in on the material issues.19
For multiple analysis, adjusting the target multiple (adding a premium for ESG
successful companies and a discount for ESG laggards).20
On a portfolio level, many investors believe that positively screened
portfolios increase excess returns, earn a positive risk premium, and may have
lower volatility.21
Naturally, the difficulty of finding timely, comparable data (or finding data
at all!) adds a layer of ambiguity to these kinds of ESG integrations, but as
pressure mounts for governments to strictly regulate the issuance of ESG data
and companies take steps to issue more standardized and broad datasets, these
calculations will become easier to make and the results they deliver will be
more accurate.