Morality and Pragmatism Can Clash for ESG Investors

As more and more assets are invested in portfolios that consider environmental, social and governance (ESG) factors, researchers are attempting to better measure the effectiveness of so-called “impact investing,” both in terms of financial performance and as it pertains to meeting the moralistic goals of ESG.

According to a new analysis published by the Center for Retirement Research at Boston College, “New Developments in Social Investing by Public Pensions,” public pension funds continue to engage in social investing, most recently divesting from Iran and fossil fuels, for example. Other institutional investors, from corporate-sponsored 401(k) plans to university endowments, are making investments that utilize “ESG screens,” and still more are instituting a combination of traditional and ESG investing.

CRR observes there is an increasing amount of empirical evidence across each of these approaches that shows incorporating ESG factors into investment decisions can at least marginally improve the investment selection process and enhance risk-adjusted returns. After all—it’s no real surprise that publically traded companies that utilize their resources more efficiently and which process waste and address social/environmental challenges more skillfully than their competitors would also perform better financially, especially over long-term investment horizons.

However, as in the wider market, there are many ESG or impact investment programs available, some of which will outperform and many more that will not. Put simply, CRR says social investing by large-scale institutions is no sure-fire financial bet, and in fact such investing is more likely to be detrimental to performance when it is so rigid as to declare whole market segments, such as oil and gas development, off limits. Further, especially in the public pension context, ESG investing can “conflict with the views of beneficiaries and taxpayers, and interfere with federal policy.”

CRR adds that social and environmental investing is often not very effective from a moralistic standpoint, either—because there is still a preponderance of market participants who have no interest in ESG or impact investing. In practice, as one large university endowment drops its shares in an over-polluting petrochemical company, for example, other investors happily step in to buy the divested stocks, potentially at a discount due to the large volume being traded. Until this paradigm shifts, it will be very difficult for ESG investments to deliver on their stated ethical and moralistic goals.

CRR concludes that, at least for public pensions in which public taxpayer dollars are being invested and for which the state carries the ultimate benefit liability, it is not an appropriate time to engage in social investing. 

NEXT: Agreement and disagreement from other providers 

Given that the investment markets include many diverse participants and providers, it’s no surprise that conflicting points of view are easy to find. In fact, on the same day the CRR published its analysis, a new study from Greenwich Associates and American Century Investments emerged, finding rapid growth in the use of impact investing among both institutional and individual investors.

To gain a better understanding of the impact investing trend, the firms interviewed approximately 75 U.S. institutional investors, more than 50 professional buyers at intermediary distribution platforms, and more than 150 financial advisers. Based on interview data, the analysis suggests up to one third of institutional investors already plan to increase portfolio allocations to impact investing in the coming three years. Fully one-quarter of the institutions/advisers surveyed plan to boost allocations by more than 10%.

Perhaps even more important to note, the research finds three-quarters of decisionmakers for intermediary platforms and 80% of financial advisers believe client allocations to impact investments will increase in the next three years.

“There is a clear—and growing—desire among institutional investors to use their investment pools to support both the financial and societal goals of participants, organizations and stakeholders,” says Greenwich Associates Consultant Andrew McCollum.

But even amid the growth, the study results reveal that attitudes and perceptions about impact investments vary widely, “and that assets of pension funds, not-for-profit endowments and foundations, and individual investors are flowing into a category that is not yet well defined … Investors also vary in their levels of satisfaction with current impact investing efforts.”

“While the vast majority of study participants say they expect impact investments to deliver at least market-rate returns, 40% of corporate pension funds and 44% financial advisers say they would be willing to accept lower returns in order to achieve a positive social impact,” the analysis continues. “Public pension funds and defined contribution plans see superior investment performance as a requirement for investment.”

Diverging from the conclusions of the CRR research, the Greenwich and American Century research suggests the belief that investments should align with personal values and societal goals is being embraced by investors of all types, “setting the stage for continued expansion of impact investing throughout global financial markets.”

“The definition and best practices of impact investing will take shape and solidify as the category attracts new participants and assets,” McCollum concludes. “During this maturation phase, investors will benefit by working with intermediaries and asset managers willing to help educate them about impact investing and define the proper role for the category within their portfolios.”

NEXT: Additional opinions abound 

A third piece of ESG research to emerge this week cuts something of a middle ground between the other reports.

According  to new survey released by RBC Global Asset Management, concerns about the environment, social welfare and corporate integrity continue to focus a spotlight on ESG factors in investing. Despite this, the research warns, most investors lack any sophisticated understanding of how ESG factors impact their portfolio.

“Many investors remain unconvinced about ESG as a source of alpha or risk mitigation—creating a perception gap that smart, active investors and managers can exploit in order to gain a competitive edge,” the analysis argues.

“It is striking to see that asset owners remain doubtful of ESG’s efficacy even as so much capital pours into ESG-related investments,” says Ben Yeoh, senior portfolio manager at RBC Global Asset Management. “Clearly, many investors have yet to understand the financial benefits of ESG. That gap, between the empirical data and perception in the marketplace, represents an opportunity that can be exploited with thorough, fundamental analysis of environmental, social and governance considerations.”

According to RBC, the survey reveals “lingering uncertainty” over responsible investing’s ability to drive financial performance and mitigate portfolio risk.

“Despite a growing body of research to the contrary, only one third of respondents said they considered ESG to be a risk mitigator,” Yeoh observes, “Even fewer (30 percent) said they considered ESG investing to be a source of alpha. This may derive from investors’ dissatisfaction with the amount of relevant data that companies are providing … Nearly half of respondents said they were somewhat or completely dissatisfied with the ESG-related information that companies make available.”

Like the other analyses, the RBC research concludes that technology, competition and other factors have made traditional equity markets increasingly efficient, and that’s made alpha outperformance increasingly difficult to come by. This state of affairs is the same one pushing increased use of alternative investments by traditional investors, and it is fueling strong growth for ESG.

“But ESG remains an inefficient or at least immature market where, because ESG factors are not yet fully reflected in valuations,” RBC concludes, “Investors who understand how to identify and properly value those factors can still gain an advantage.”