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Mike Tocheri

I subscribe to newsletters, periodicals, and mainstream news outlets, and environmental, social, and governance (ESG) investing is a topic I come across at least weekly. When I get invited to a conference, ESG is likely on the agenda via a panel or guest speaker, and it is hailed as the most important investing trend of today and tomorrow. 

Yet, in my business, where we support hundreds of independent wealth professionals, ESG is rarely discussed. When I informally surveyed a few clients to find out if ESG investing was top of their minds, the majority said no… not yet. 

I therefore want to explore ESG from a different perspective. Who is investing, and where are the inflows coming from? How are the returns? How is ESG itself governed? In this article, I try to take a balanced, objective approach to this important investing topic. 

ESG investing—that is, investing that takes environmental, social, and governance goals into consideration—is undoubtedly an important approach to investing and one that has seen dramatically growing interest, especially over the last decade. But it is essential to understand that ESG investing is not a magical panacea for your investment portfolio. Neither is it necessarily the wrong choice for your investments. 

Where the Interest in ESG Is Coming From 

There is a great deal of conjecture and opinion in the ESG investment space—but I like facts and data, so I want hard evidence. When you look at the statistics related to ESG adoption, what becomes clear is that, to date, it seems to be primarily driven from the top down and by a growing, but still relatively small, segment of the retail market. 

A recent survey asked decision makers in the energy sector about the factors contributing to the implementation of ESG investment policies. Close to half of the respondents (48 percent) highlighted board mandates and regulatory pressure as key factors driving change. Bottom-up investor pressure in favour of ESG investing was cited 44 percent of the time, and other factors such as industry standards, employee demands, or a general desire to do public good were all only cited between 24 and 35 percent of the time. Now, obviously this is the most-discussed sector in relation to ESG investing today, but I wonder if these same drivers were the catalysts in other sectors as well. 

Figure 1. Reasons for implementing or considering implementation of ESG policies in the energy sector worldwide, as of September 2021 

Source: Womble Bond Dickinson.“Reasons for Implementing or Considering to Implement ESG Policies in the Energy Sector Worldwide as of September 2021*.” Statista, Dec. 7, 2021. 

Board pressure for ESG involvement is driven primarily by the understanding that, if ESG standards are not considered, institutional investors led by public and private pensions (which need to be compliant with their internal ESG commitments) won’t invest in specific companies or funds, nor will many direct investors. While certainly not zero, we don’t see as much ESG investment driven by the individual (professionally managed) wealth space. So, if I’m a mutual fund or exchange-traded fund (ETF) manufacturer, do I have to have an ESG portfolio? 

We also must ask how much of the interest in ESG investing is generational. Younger investors appear to be the largest and most interested retail cohort in ESG-compliant investments. But there is evidence to suggest that Generation Z (the generation younger than the millennials) and investors 40 years and older don’t show the same demand for ESG investments as millennials do. That being said, with the massive generational transfer of wealth coming from baby boomers and Gen X to millennials and Gen Z, the demand for (and importance of) ESG investing as these cohorts come into their inheritance, will only grow. 

We are seeing slow and steady—but not immense—ESG growth in the individual professional management space. To examine this, we can focus on the performance of two Canadian ESG ETFs. The chart below shows inflows of the Wealthsimple North America Socially Responsible Index ETF (WSRI) and the Wealthsimple Developed Markets ex North America Socially Responsible Index ETF (WSRD). 

Figure 2. Wealthsimple North America Socially Responsible Index ETF (WSRI) and the Wealthsimple Developed Market (except North America) Socially Responsible ETF (WSRD). 

Source: Bloomberg L.P. Wealthsimple North America Socially Responsible Index (WSRI) and the Wealthsimple Developed Market (except North America) Socially Responsible ETF (WSRD). [Data set]. Accessed March 8, 2022, from Mike Tocheri’s Bloomberg terminal.

As the chart shows, inflows have been steadily increasing over the past six months. To date, there are seventeen million units for WSRD and fifteen million units for WSRI outstanding, together just shy of CA$1 billion in assets under management. 

But Just What Are We Investing in with ESG? 

This is where the waters cloud, however. Like nebulous designations of goods as “organic” or “fair trade,” there is no standardized definition of what makes for effective ESG criteria or agreed-upon metrics for how ESG qualifications are best measured. 

So, with somewhat vague standards and metrics, investment managers must pick and choose which companies will form their ESG options, and which will not. A company that qualifies for one advisor’s ESG portfolio may not make the cut for another advisor. 

For example, there are few ESG portfolios involved in energy or oil. With inflation on the rise, both energy and oil prices will follow suit, and we can expect to see increasing profits in those sectors. It should go without saying that ESG investors will miss out on the potential windfall these companies will experience in the coming months. Or will they? 

The same is true for companies like Raytheon, Northrop Grumman, Lockheed Martin, and any other defence contractors. Given the situation in eastern Europe and with geopolitical tensions on the rise, the demand for their products and services will likely grow, as will the profits they reap, as sad as that is. So how do ESG portfolios compete? Some tongue-in-cheek Twitter discourse, for example, has speculated that ESG funds might incorporate defence companies before energy companies based on ideological opposition to fossil fuels, especially if (as is the current case with Russia) that energy comes from countries with hostile regimes. What such banter really highlights, I suggest, is that ESG standards could suffer from political whim on the part of unknowing ESG investors. 

Comparing Returns of ESG and Non-ESG Investments 

A point in favour of ESG investing, however, is that when you look at the numbers, the S&P 500 ESG benchmark outpaced the S&P 500 by 3 to 3.5 percent between 2019 and 2021. Clearly, there is money to be made in ESG investing. However, it remains unclear to me if the most substantial returns in ESG investing might be self-driven by the capital inflows into these products creating self-fulfilling price increases in the underlying names or is it from their relatively heavy tech weighting (which has seen tremendous returns in the past 24 months), or is ESG inclusion evolving with economic trends by adding new sectors not previously included. 

Figure 3. S&P 500 ESG vs. S&P 500, March 2019 – March 2022 

Source: S&P Global. “Comparison of the Effect of the S&P 500 ESG and S&P 500 Indices between March 2019 and March 2022 (in Standardized Index Points)." Statista, March 15, 2022.1 

What will the performance of the S&P 500 ESG benchmark look like over the next few years, given the new macroeconomic and geopolitical situation we find ourselves facing in 2022? It will be interesting to see whether this trend reverses itself, or if new ESG standards simply find a way to include cyclical economic sectors that might otherwise be considered in the ESG “red zone.” Has it always been this way? 

The Importance of ESG Methodology in the Investment World to Come 

ESG is not yet a driving factor for many portfolio managers, whether institutional or independent. 

Most portfolio managers base their analysis on traditional fundamentals when making investment decisions. There are still very few portfolio managers today who focus exclusively, or even primarily, on an ESG model. 

However, I believe they are all paying close attention. 

Portfolio managers need to respond to client demand, and, as I’ve already pointed out, ESG considerations will be increasingly important as younger investors become a force in their own right. Requests for ESG options will become increasingly commonplace from both funds and retail investors, so portfolio managers will need to independently plan for how to service those requests. Such planning will be especially important for dealing with investors who declare their intention to be 100 percent in ESG-responsible investments. 

Portfolio managers will likely be aided in this endeavour by corporations themselves. Many companies aim to be 100 percent ESG compliant in the next five to fifteen years. This will allow them to offer the best of both worlds: meeting traditional economic fundamentals while also being attractive to ESG investors. I struggle to think of a company that doesn’t have an ESG transition plan. 

But we’re not there yet. ESG investment so far is not the massive shift or broad movement that many would have you believe it is. It is a slow but steady change in investment priorities—one that will likely continue to grow over time in a similarly steady fashion. 

What This All Means 

There’s no doubt that ESG investing is here to stay. ESG is widely adopted by public and private pensions and arguably appeals to younger individual retail investors. 

There will likely need to be standardization of some sort for the general investing public to know which companies and investment products meet ESG criteria. The dichotomy between the generally accepted moral standards of ESG investing and investment returns, I argue, will be ESG’s toughest hurdle in the next few years. 

There is still a difference between those investing from the point of view of morality and those investing from the point of view of economic fundamentals. Over time, however, both clients and investment managers will likely benefit from a global move toward ESG compliance at the corporate level, leading ESG investing to become a standard method of operation as all large companies become compliant. 

At that point, ESG investing will no longer be necessary as a concept. It will simply be the norm. 

Find an earlier version of this piece on my LinkedIn profile and let me know what you think 

Senior Vice President and Managing Director, National Bank Independent Network 

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