ESG Investing Process: Evolve or Go the Way of the Dodo

In Brief

• Firms with ESG-focus yielded historic returns in 2021.
• ESG popularity elevates scrutiny from regulators and investors.
• To navigate the change, asset managers must incorporate ESG within their investment processes. 

Only ‘Minor Wobbles’ for ESG

The global pandemic contributed to record-breaking inflows into ESG funds. Sustainable investment inflows, however, are not a short-term coincidence. Rather, they’re part of a broad permanent trend.

ESG funds accounted for 90% of global fund inflows in July 2021, according to the Financial Times. At the same time, overall equity inflows dropped in July 2021 — making that inflow number even more striking.

Edward Glyn, head of global markets at Calastone, said ESG funds had proven to be a real game changer. “Investors seem to view them as a class apart – even after two years of dramatic growth, the trend of inflows is still firmly on an upward path, with only relatively minor wobbles when the wider stock market is down,” he said.

Glyn continues, “Most ESG funds are actively managed, so the ESG gold rush is masking what are in fact much more normal trading patterns for ‘traditional’ active equity funds – flows for these funds are still just as driven by sentiment as ever. In the last two years, non-ESG active funds have seen outflows in more than five months in 10.”

Record Highs for ESG-Focused Funds

Funds focused on environmental, social and governance (ESG) related issues saw their combined assets climb to $3.9 trillion at the end of September – a new record, according to Reuters. The growth was mainly due to a significant increase in the number of funds meeting Morningstar’s “sustainable investment” criteria in Europe, following the introduction of the Sustainable Finance Disclosure Regulation (SFDR) on March 10.

Further, the number of sustainable funds captured in Morningstar’s global sustainable universe has grown by more than 51% over the third quarter, reaching 7,486 funds at the end of September, the report said. According to SFDR, firms (including fund houses, insurers and pension funds) that provide financial products or services in the European Union will have to begin disclosing how sustainable they really are.

ESG Scrutiny on Asset Managers

As ESG-related capital increases, however, so does scrutiny from investors.

More than ever, active managers can feasibly market funds as “ESG-integrated” that are constructed largely based on third-party ratings data. An observer might assume this type of portfolio would be offered by an active manager aiming to justify fees by ‘checking the ESG box.’ But the fact is that investors who do not properly scrutinize managers processes are key contributors to this dynamic.

As quickly as ESG AUM has risen, so have concerns over lack of clarity on ESG standards and potential greenwashing of investment funds.

That’s why it’s so important for asset managers to be able to have discussions with their investors about their internal approach. Third-party ESG ratings data is a great place to start; however, active managers will need to go further in future. Terms like stewardship and proprietary ESG ratings will continue to become more mainstream.

The Bottom Line

ESG ratings offer investors a great starting point for measuring companies. The datasets and models that govern them, though, are becoming more sophisticated. For investors seeking to maximize inflows, leveraging ESG ratings as a core part of stock selection and portfolio monitoring is not only logical, it’s essential.

As investor demand and total AUM continue to grow, we’re going to see changes — and hopefully improvements — on all fronts.

Ratings will become more sophisticated and bespoke. Impact measurements will mature. New regulations and investor demands across all major market regions will drive transparency. Managers who deploy a strategic, thoughtful approach to sustainable ESG investment and ESG ratings are more likely to navigate these evolving ESG challenges and be rewarded for their efforts.

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