Environmental, social, and governance (ESG) strategies are having their moment of well-deserved glory. Once viewed as a niche investment approach that required concessionary returns, ESG has shown believers and non-believers alike that its integration in the investment-making decision process can lead to desirable results. In June, Morningstar reported that ESG and sustainable fund flows leapt 72 percent, helping ESG investment assets reach a record high, $1 trillion.
Although interest in ESG was growing prior to the COVID-19 pandemic, investors’ funds flowed to such strategies as the global health crisis unfolded. Not shocking, considering that sustainable equity funds outperformed their traditional peers in 2019 and January – June 2020 by a median of 2.8% and 3.9%, respectively.
Skeptics still remain. In the most recent downturn, the fall in energy coincided with the pandemic. Some were quick to claim that ESG is merely a matter of luck, as most sustainable strategies have limited, if any, exposure to fossil fuels. Also, one quarter on its own is not enough to prove the benefits of ESG. So, the question for some remains: is ESG performance sustainable? The answer is yes, when ESG is applied correctly.
ESG is our core discipline
At Reynders, McVeigh, ESG has always been a tool we rely on in our research process especially when considering the mitigation of risk. Material non-financial factors are where we believe liabilities exist for companies that are not always expressed in metrics. The COVID-19 pandemic placed a spotlight on issues such as supply chain resiliency, contingency planning and most importantly, human capital management – all factors that are inherently part of a thorough ESG analysis.
That analysis is part of a core fundamental analysis at Reynders, McVeigh – and has protected our portfolios from significant market downturns. The companies that interest us are those that exhibit strong ESG characteristics, but what is equally important is their financial strength as a company. This begins with a strong balance sheet and forward-looking management. By way of example, both the 2020 and 2008 downturns were exacerbated by the amount of leverage in the system. Our process keeps us away from companies trending towards higher leverage, thereby mitigating this risk factor.
With ESG gaining favor among investors and managers alike, the amount of ESG strategies or products is, in a word: overwhelming. This influx of ESG has led to a “broad-brush” application of the approach that falls back on dated “bad habits” of SRI, for example relying heavily on negative screening. This method of investing excludes so-called sin stocks and essentially “checks the box.”
At Reynders, McVeigh, we instead emphasize positive screening, seeking out equities that demonstrate strength of balance sheet, dependability of management, and a commitment to act as part of a global community focused on positive change.
Active vs. Passive
There has been a migration to indexing – one of the most common forms of passive investing. This relies on a “broad-brush” application of aiming to mirror a whole stock market or index by investing in everything. In addition to our reservations noted above, indexing investment strategies use data or fact packages from ESG ratings and rankings providers. From our perspective, this leads to two potential issues: rating and rankings are often backward looking, which is not always helpful when making an investment decision about the future; also, there is no guarantee that the company is indeed sustainable. This is how greenwashing can occur. Simply because a company meets or scores well on particular E, S, and G criteria, they can be included in a portfolio regardless of their core business.
Our role as active investors means that we build portfolios based on intense due diligence, and we always know what we own. We are able to find investments away from the pack and make informed decisions on individual holdings, rather than relying on indices that may lead us in the wrong direction.
What is material? The answer to which non-financial factors are likely to affect financial performance will be different based on who you ask and when. At Reynders, McVeigh, off the shelf ESG ratings and rankings are a data set and starting point. We believe that practitioners of ESG that dig deeper than these pre-fab packages have a better understanding of materiality – that it can be relative to companies and sectors. This is why we use our own proprietary ESG data analytics tool, OWLshares, to consider a wide set of ESG metrics we believe affect company performance.
So, is ESG performance sustainable? When you simply look at the numbers, the answer is yes: sustainable and ESG strategies tended to outperform in 2019, the fourth quarter of 2018the downturns of 2015-16. When it comes to our approach, the elements discussed above are just some of the factors we consider when acting as stewards of our clients’ capital. Protecting our clients and their beneficiaries from unnecessary risk is paramount and the foundation on which we pursue long-term success.
Disclosure: The views expressed above (the “Insight”) are those of the authors and Reynders, McVeigh Capital Management, LLC (“RMCM”) as of the publication date and are subject to change at any time based on market or other conditions. This Insight is for informational purposes only. It does not constitute investment advice or a recommendation to invest in a particular manner. RMCM may not achieve the objectives described in the Insight. Statements regarding potential events or outcomes in the future are not guarantees of future performance, and actual results or developments may differ materially from those statements. All investments involve risk, including a loss of principal, and RMCM’s past performance is not indicative of future results. RMCM assumes no obligation to provide the audience with subsequent revisions or updates to any historical or forward-looking information contained herein.
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