Your complete guide to socially responsible investing

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ESG investing — or strategies that take a company’s environmental, social and governance factors into consideration — grew to more than $30 trillion in 2018, according to Global Sustainable Investment Alliance, and that number is set to keep rising as consumer tastes shift and investors demand more transparency. Once a niche approach thought to come at the expense of returns, these strategies have proven that they can be market-beating. And as investor momentum builds, some argue that companies can no longer afford to discount their ESG ratings.

Definitions of “ESG” are wide-ranging. The inherently subjective nature can make these factors hard to quantify — my good could be your bad.

Putting that aside, here we’ll take a look at the evolution of ESG investing — what’s behind the drive, especially as millennials and Gen Z take over the workforce, and the very real implications for companies that do not act. We’ll also consider some of the most popular ESG strategies, including ways in which investors can buy into the socially responsible investing movement.

ESG is already big, and it’s only growing. According to predictions from Bank of America, another $20 trillion is set to flow into ESG funds over the next two decades, which the firm called a “tsunami of assets.” For context, the entire S&P 500 is worth about $25.6 trillion.

These strategies are not new. The term “ESG” was coined in 2004 and the idea of investing with a broader goal in mind has been around for decades. But while taking this approach was once an exception, it’s now becoming the norm. More than 2,250 money managers who collectively oversee $80 trillion in assets have now signed on to the United Nations-backed Principles for Responsible Investment.

Traditionally some argued that taking this approach could mean sacrificing returns. But research suggests otherwise. There’s no shortage of ways in which to enact an ESG style, but perhaps the most basic approach — buying ESG-focused ETFs that track indices — have shown to yield returns similar to their benchmarks. Nuveen ESG Large-Cap Growth and iShares ESG MSCI USA are such examples. Both are beating the S&P 500 this year.

“This is not in any way concessionary to returns. We actually think it’s going to improve returns because it’s going to help us select better companies to invest in,” said Cliff Robbins, founder of $2.2 billion hedge fund Blue Harbour Group, at “Delivering Alpha” in September. “I think it’s so powerful. I’m telling public company CEOs that I’m investing in today that three years from now their P/E is going to be affected by their ESG rating.”

Within sustainable investing, styles range from ESG integration, to socially responsible investing to impact investing. Put simply, the primary factor in ESG integration is still financial performance, while impact investing is meant to maximize, with a quantifiable impact, societal reach. Socially responsible investing is somewhere in the middle.

Different reasons fuel investors’ appetite for ESG strategies. Some do it for moral reasons, choosing to completely shun companies that do not align with their views. Others, and the majority, consider ESG factors from a financial risk standpoint. For example, if a company doesn’t employ equal pay practices, there could be backlash and a high turnover rate which could, in turn, impact the stock performance.

But as these strategies gain popularity so, too, do the issues surrounding this approach. For one, it can be difficult to assign an ESG “score” to a company since many of the factors like brand appeal, for instance, are subjective. It can also be hard to prove that ESG is, in fact, being integrated into investment divisions. And some say that while ESG can weed out bad behavior it’s not sparking innovation and moving the ball forward on things like climate change.

While there might be an array of approaches to ESG investing on the Street one thing is certain: it cannot be ignored.

If sell-side research from Wall Street firms is any indication of market sentiment, investors are really interested in ESG. Analysts are devoting more and more pages to ESG strategy reports, and many firms are integrating ESG analysis into their regular research notes.

“ESG … looks set to dominate investors’ agendas in the years ahead,” Credit Suisse said in a recent report, and Bank of America said that “70% of US assets can’t be analyzed without using ESG.”

“As ESG issues become increasingly material across many industries, our GS analyst teams have taken pen to paper to address the impact on corporates,” Goldman Sachs analysts said in November.

“The demand for Sustainable Investing has been clearly growing over the past year,” JPMorgan noted.

As investors’ interest has spiked, the Street has taken note. New ETFs and mutual funds focused on ESG strategies have launched in record numbers, and there are a number of different ways for investors to deploy their capital in ESG strategies.

According to data from Morningstar, this year, through the end of November, $17.76 billion flowed into sustainable-focused ETF and open end funds available to U.S. investors. Last year’s total inflow reached $5.5 billion, which was then a record high. 2019’s number has already tripled that, and the year isn’t over.

“Increasingly proactive, they [individual investors] seek products and solutions across asset classes tailored to their interests. They also want to measure the environmental and social impact of their investments,” Morgan Stanley said in an Institute for Sustainable Investing report.

One of the initial criticisms against ESG investing was that it meant compromising on returns. Of course, if you limit your options you could potentially sacrifice financial performance.

But the data tells a different story. 65% of sustainable funds rank in the top half of their respective Morningstar category through November, the firm said, and 48% of large-cap blend sustainable funds are beating the S&P 500 this year. By comparison, overall only 26% of large-cap blend funds are beating the market.

The longer-term figures show a similar trend. Morgan Stanley analyzed the performance of nearly 11,000 ESG-focused funds from 2004 – 2018, using data from Morningstar, and found that performance was comparable with that of their non-ESG focused peers.

“The returns of sustainable funds are in line with those of traditional funds, while also offering lower downside risk for investors,” the firm said in its Sustainable Reality report. “What’s more, in an uncertain market, sustainable funds may offer a layer of stability for investors looking to reduce volatility.”

There are many ways to incorporate ESG strategies into a portfolio, and one thing that just about everyone agrees on is that there’s not a “one size fits all” approach.

According to the Global Sustainable Investment Alliance, negative and norms-based screens are among the most common approaches. The first one means avoiding one category of stocks entirely — tobacco, for instance — while the latter is based on compliance with international standards established by organizations like the OECD or the United Nations Global Compact.

ESG integration is another popular method that’s gaining steam. This is when an investor takes into consideration a company’s ESG profile — and any potential risks — as one of the evaluated factors when considering whether or not to buy a stock. This analysis can be done independently, and then there are also a number of agencies that provide research and issue ESG “scores.”

ESG-focused shareholder activism is another approach that’s gaining traction, particularly as investors call on the country’s largest investment management firms — sometimes a company’s largest shareholder — to push for change.

Generally speaking, the first priority for ESG integration strategies remains financial performance, while impact investing’s focus is the greatest possible societal reach. This latter form of investing can be difficult for individual investors to access through the public market.

Morningstar’s head of sustainable research Jon Hale said that he’s seeing large inflows into diversified sustainable funds, or funds that could be substituted for an investor’s conventional holdings. These funds track indices like the S&P 500 or the Russell 2,000, but an ESG evaluation is central to the fund’s security selection process. Factors like a stock’s weighting, for example, could differ from the benchmark.

Examples of this type of fund, all of which are beating the S&P 500 this year, include: Nuveen ESG Large-Cap Growth (NULG), ClearBridge Sustainability Fund (LCISX), UBS US Sustainable Equity Fund (BPEQX), Aspiration Redwood Fund (REDWX) and Calvert Equity Fund Class (CSIEX).

Hale said there’s been an especially noticeable increase in money going into sustainable fixed income funds, in part because a number of new funds have launched. “More investors I think are starting to understand that they can use ESG funds, sustainable funds across their entire portfolio,” he said to CNBC.

In some smaller areas of the sustainable investing landscape funds are posting returns far ahead of the market. This is especially true of some renewable energy-focused funds. Invesco Solar (TAN), Invesco WilderHill Clean Energy (PBW), ALPS Clean Energy (ACES), SPDR S&P Kensho Clean Power (CNRG) and Shelton Green Alpha (NEXTX) have all returned more than 40% this year.

It is important to note, however, that these funds can be volatile. While Invesco’s solar fund has surged 60% year-to-date, it ended 2018 with a 26% loss.

When it comes to evaluating specific stocks, things can get tricky. There are some companies that obviously fall into either the “E,” “S” or “G,” but the holistic picture might be harder to judge.

ClearBridge Investments portfolio manager Derek Deutsch said that he looks for companies that are “best in class” with “very strong sustainability profiles.”

“We want companies with sustainable competitive advantages, and that would include excellent corporate governance, and companies that treat their employees well, interact in a positive way in communities where they’re located, etc.,” he said to CNBC.

Ball Corporation and Trex Company are among the holdings in the ClearBridge Sustainability Fund that Deutsch manages.

The former is a Colorado-based manufacturing company which, among other things, makes aluminum beverage cans. Demand for aluminum is growing since it’s a much more sustainable material than glass or single-use plastic. Deutsch said that the company’s seen volumes double, driven in part by rising sales from carbonated drinks and craft beers. The stock has gained 38% this year. “We think this is going to be a secular trend because everyone is concerned about these issues,” he said.

Trex Company, the fund’s fifth largest holding, makes house decks from recycled plastics. The stock has gained 50% this year as the company takes market share from traditional lumber manufacturers. Deutsch said he believes the company can double earnings in the next 3-5 years.

ClearBridge Sustainability Fund has an ESG mandate, so it might come as a surprise that the top four holdings are Microsoft, Apple, Alphabet and Costco. Deutsch said that part of what they consider when determining whether or not a stock belongs in the fund is the societal impact of the product or service that the company offers.

When it comes to top-holding Microsoft, for instance, he said there are a number of factors that make it a “sustainability leader,” including their productivity-enhancing software. He also noted that the company has been progressive on a number of social fronts, and that they’ve pushed to source energy from renewable sources.

This particular fund has no exposure to any company that’s primarily engaged in fossil fuel extraction or mining, although other funds at parent company Legg Mason, which has $790.5 billion in assets under management, could have exposure to traditional oil companies.

ESG analysis is also playing a greater role in sell-side research from Wall Street analysts.

For instance, DA Davidson said that TJX, Lyft, Etsy and Synovus are among the buy-rated stocks in their coverage universe that look best from a governance standpoint. In a recent report JPMorgan said its top alternative energy picks going into 2020 are First Solar, SolarEdge and Sunnova Energy as investors pivot to cleaner sources of energy.

Taking a more thematic approach, Credit Suisse said the most attractive areas within sustainable investing are education, future of work and healthy living. Based on this, they scanned their analyst coverage looking for outperform-rated companies that fall into these categories, and found that Informa, Honeywell, Stryker and VF Corporation are among the companies that look best from this standpoint.

The key driving factor behind the surge in ESG investing is most probably investors’ demand for clarity when it comes to a company’s stance on social issues, as well the significant financial consequences that a company can face if it fails to adapt to changing consumer behavior.

Europe has traditionally been a leader when it comes to ESG, and a new wave of regulation is set to accelerate how investment managers account for ESG factors. But the United States is catching up.

“Unquestionably we are seeing more ESG demand worldwide and probably the biggest net changes in demand in the U.S.,” BlackRock Chairman and CEO Larry Fink said on CNBC’s “Squawk Box” in 2018.

Credit Suisse found that more than 85% of S&P 500 firms now disclose ESG information, up from just 20% in 2013, as “investors globally have become increasingly engaged with the concept of ‘responsible investing.'” This means a growing reward for those that score well on ESG metrics, with steepening consequences for those that do not.

“While many would argue that much remains to be done in order to achieve long-term sustainability targets, we stress that the growing focus on them by investors and the wider public is starting to have a real impact … ESG is increasingly driving investor agendas. We see this focus only increasing,” the firm added.

ESG investing may have started out with moral goals at the forefront, but as society changes it’s now viewed as an imperative metric when looking at a company’s future potential.

Calvert International Equity Fund portfolio manager Ian Kirwan used the example of electric vehicles. A few years ago many automakers weren’t interested in EV since it’s hard to make money without government subsidies. But suddenly they had to catch up with companies like Tesla as regulators, as well as consumers, pushed for greater EV adoption.

“What started off as ESG-related issues, or sometimes controversies, they used to sit on the side of the stage. And all of a sudden they’re getting catapulted right into the center of the stage,” Kirwan said to CNBC.

In an effort to maximize returns, ESG-related issues and any resulting stock impact is one of the many factors taken into consideration at Calvert, which is a division within Eaton Vance’s $497.4 billion in assets.

“We use ESG as a source of information to hopefully tell us something about the investment we’re looking at. We don’t treat it with anything special … it is one of a number of different components that we use to paint the holistic picture,” he said.

One potential issue with ESG investing is that it can be difficult to prove that these factors are truly being considered, so Kirwan said that he helped develop an approach to make sure it’s not just an afterthought.

At the most basic level, the firm breaks every company into four buckets of information, where it’s then evaluated on metrics like capital allocation and cash flow. Kirwan said that rather than creating a fifth and final bucket for ESG questions, it’s instead considered alongside all of the more traditional financial factors.

But companies that rate poorly on ESG metrics can also create potential buying opportunities, particularly if investors think they can encourage change at the company in question.

This is part of Pzena Investment Management’s strategy. The firm, which oversees more than $38 billion, uses a deep value investing style, which means it targets the cheapest quintile of stocks — including those that might have unfairly sold off.

“Sometimes we might reject a stock for an ESG reason. Sometimes we might actually see that the ESG reason is part of the reason why the stock is cheap, but also part of the potential turnaround, and we have confidence in management to help fix some of those issues,” Pzena Investment Management ESG analyst Rachel Segal said to CNBC. This ESG-lens is one of the many ways in which the firm approaches a stock.

“From our perspective it’s really about the material risks to the investment and understanding how we can analyze those in a way to try and get the best risk-adjusted performance for our clients,” she added.

Pzena Investment Management is one of the signatories of the “Principles for Responsible Investment.”

The wide-ranging definition and inherently subjective nature of the term “ESG” means there are plenty of critics of this methodology. Some investors say that fossil fuel companies, for example, have no place in socially conscious funds. Others argue that since companies are going to be producing oil no matter what, investors should reward the best actors.

Given the sheer volume of information required to judge a company’s environmental, social, and governance profile, a number of research firms have sprung up that score companies on these factors, including Sustainalytics, As You Sow and MSCI.

Simon MacMahon, head of ESG research at Sustainalytics said that the main focus of the rating is to evaluate the degree to which companies face ESG issues that lead to unmanaged ESG risk, and therefore potentially negative economic outcomes.

“It’s a two-dimensional rating in that it looks at exposure on the one hand, so the degree to which companies are exposed to issues and how much. And then the degree to which they are managing those issues, and what is the gap between those two components,” he said to CNBC. “We take as much as possible a data-driven approach, and it’s a very structured approach,” he added.

He said that Sustainalytics recently overhauled its rating system, and that it now offers “absolute” ratings which allows for companies to be compared across industries. The majority of the company’s clients are institutional investment managers, although through the company’s partnership with Morningstar, MacMahon said that more and more retail investors are using their data.

But some say that too much credence is given to these ratings, given that significant investment decisions can be made based on them, and also since scores can differ drastically between research providers.

In June SEC Commissioner Hester Peirce likened the affixing of E, S and G labels to Nathaniel Hawthorne’s “The Scarlet Letter.”

“In our purportedly enlightened era, we pin scarlet letters on allegedly offending corporations without bothering much about facts and circumstances and seemingly without caring about the unwarranted harm such labeling can engender,” Peirce said.

If the last decade saw ESG become mainstream, the next ten years will likely bring a new wave of shareholder-driven accountability from the world’s largest companies.

As issues like climate change and global poverty become more immediate, and as megatrends are set to take shape, people will increasingly call on the most powerful players to take action. Corporations will have to step up, and ESG metrics will need to crystallize.

“The largest investors in the world, which control how stocks are ultimately valued, care about this. Endowments and foundations are totally focused on ESG considerations … pension funds care about it, labour unions care about the safety of their employees … the biggest asset managers in the world have now awoken and said ‘ESG matters to me,’ and therefore it’s going to matter to companies,” Robbins said.

– CNBC’s Michael Bloom contributed to this report.