There are 26 letters in the alphabet, but just three of them have revolutionized the investing world over the last few years: ESG.
Investments that incorporate “environmental, social and governance” factors have quickly gone from a fringe theme to a dominant one. According to a new report from nonprofit foundation US SIF, there were $17.1 trillion in sustainably invested assets in the U.S. at the start of 2020.
That's up from $12 trillion just two years prior, making for a 42 percent increase. In fact, ESG now accounts for a third of all professionally managed assets in the country.
And while climate has so far been the predominant focus of sustainable investing, attention has begun to shift.
“ESG has largely been focused on the ‘E,’ and the ‘S’ was almost the forgotten middle letter,” says Kent McClanahan, vice president of responsible investing at RBC Wealth Management-U.S. “But 2020 was the year of the 'S'. Events really put the spotlight on social justice, and that was borne out for the rest of the year.”
Indeed, social justice was perhaps the key theme running through the events of 2020: The effects of systemic racism, inequality in access to healthcare and justice and education, and extreme wealth imbalances were seemingly laid bare on a daily basis.
A year of social focus
For companies, industries and investors, ignoring social justice factors can represent a very real risk. A destabilized society—whether it's the mistreatment of workers, a lack of diversity and inclusion, or poor community relations–is simply bad for business.
That helps explain why, in the 2020 US SIF report, the total amount of assets invested with a “social” focus actually exceeds both the “governance” and “environment” subcategories.
For proof of the trend, just look at the headlines that dominated 2020: The protests over the killings of George Floyd and Breonna Taylor, for instance, and the Black Lives Matter movement that's reshaped American society and political debate.
Corporate America has traditionally been reluctant to wade into social and political issues, but it proved impossible to ignore in the aftermath of 2020. Witness the content of earnings calls for S&P 500 companies: At the beginning of the year, under 10 percent of firms had a mention of diversity and inclusion, says McClanahan.
After the year's second quarter, that spiked to 40 percent. “It shows companies started thinking about it a lot,” he says. “It became the focus of the whole year.”
Investors pursue positive change—and positive returns
Just as companies started focusing on social justice themes, so too did investors. With women investors and younger generations starting to control more assets, there's been a marked shift towards investing sustainably, rather than a focus solely on returns at all cost.
One trending question investors are asking their advisors: How can I make sure these principles of social justice are accurately reflected in my portfolios?
“At RBC Wealth Management we have several different resources for those investors,” says Kevin McDevitt, senior VP and director of Global Manager Research at RBC Wealth Management-U.S. “For clients who want to keep it simple, they may want to consider pre-constructed ESG portfolios. For investors looking for more choice, there are a number of ESG mutual funds or ETFs for them to consider as they construct their own portfolio. For those who want to take it to the next level, they can get even more customized by using managed accounts to align underlying investments with their values as much as possible.”
In the past, that kind of hyper-customization has been a challenge. After all, a broad concept like 'social justice' is harder to quantify than, say, profit or loss figures on an earnings report. But as company reporting on this trend gets better, and data providers continue to innovate, a social justice-oriented portfolio has now become possible.
Using data screening to align portfolios with values
That's where ESG ratings firm Sustainalytics comes in. As a global leader in ESG research and ratings, it partners with RBC, via the advisory platform Envestnet, to allow clients and advisors access to its trove of information.
“It allows our clients to implement screens of their own,” says McDevitt. “For example, there is a Social Justice Screen with subcategories like predatory lending, riot weapons, human rights, labor relations and community relations.”
For high-net-worth investors who hold separately managed accounts, they could use Sustainalytics data as an “overlay screen” to identify companies that don't align with their principles, and subtract them from the portfolio.
Alternatively, on the positive side, they can identify companies that are helping bring about meaningful change in areas like health care access, affordable housing or education, and consider inclusion in their portfolios.
Younger investors usher change in wealth transfer and values
Among younger investors, especially, this kind of socially-conscious investment capability is seen as not just a nice option to have, but a necessity.
“There's a generational transfer of wealth going on, and a shift in values as well,” says Tatsiana Yakautsava, a senior associate with Sustainalytics in Toronto. “They want to be equipped with as much ESG information as possible, to align their investments with their values.”
Of course, the desire for positive social change is one thing, and the desire for investment returns is another. If an ESG focus required an investor to accept subpar returns in his or her retirement portfolio, that's a very big ask.
Thankfully, though, this is not an either/or proposition. The evidence gathered so far suggests investors can generate positive social impact without harming their own future portfolio gains.
Positive returns—even in a pandemic
“Our ESG Risk Ratings are grounded in a view of financial materiality, to provide insight into the full array of risks and opportunities that companies face,” says Yakautsava.
Morningstar's annual analysis of ESG-screened indexes has found that 75 percent outperformed their broad market equivalents in 2020, and 88 percent outperformed for the five years through the end of 2020.
That might sound surprising at first, but it stands to reason. If a firm is able to minimize such social justice 'risks'–if it has harmonious relations with its workers, and boasts a diverse and thriving C-suite, and is seen positively by the community—then it should enjoy some downside protection, no matter what world crisis comes its way.
As 2020 taught us, those social crises will come—perhaps many at the same time. But by acknowledging those risks, taking productive action, and reflecting the values of a growing number of investors, forward-thinking companies should be able to survive and thrive in a rapidly changing world—and provide returns to shareholders at the same time.
“This area of social justice now has a spotlight on it, and it's just getting started,” says McClanahan. “A lot of companies have made commitments to issues like leadership diversity, and are now following through on it. Social justice will continue to be a big part of the investing conversation going forward.”