ESG Investing Slowly Going Mainstream

Although many investment managers see the growth of ESG as a permanent shift that will influence the long-term investment strategies they implement for clients, most managers only consider it to be somewhat important for managers to offer ESG capabilities today. Cerulli notes this is a significant development, however, as most asset managers have historically thought of socially responsible investing as a niche area that appealed only to religious groups and certain other mission-based, nonprofit organizations.

Today, managers are observing increased demand for ESG from all types of clients and prospects, Cerulli says, especially in the institutional and retirement planning channels (see “Running the Fund: Looking Ahead Responsibly”). As Cerulli explains, institutional sales teams increasingly report that large asset holders, such as defined contribution and defined benefit retirement plan sponsors, are inquiring about the potential benefits and drawbacks of ESG strategies.

Cerulli says request-for-proposal (RFP) teams at investment management firms are reporting a significant rise in the number of RFPs with embedded ESG-related questions. The questions encompass several areas, from the fiduciary implications of implementing an ESG portfolio to the potential environmental or political risks that can be addressed by ESG screening strategies.

As explained by Cerulli, ESG investing strategies can be enacted in a variety of ways. One common approach is to apply “ESG screens” to a portfolio, through which the manager cuts out investments in securities that are sensitive to things like water shortages, food scarcity, or social unrest/injustice. Cerulli researchers suggest there is increasing acceptance among institutional investors and asset managers that ESG factors can have a material impact on the security-issuing company’s financial well-being, as well as overall capital market performance (see “Running the Fund: Win-Win”).

Some industry professionals point to the long-term nature of the potential impact of ESG factors on a given company or security as dilutive of ESG’s importance in the portfolio-building process, Cerulli explains. This is an especially important matter in the retirement planning context, wherein plan sponsors and other named fiduciaries must make all investing decisions in the best financial interest of their participants. The Department of Labor (DOL) has even issued guidance reminding plan sponsors that ESG factors, when they are not clearly material to the performance of a given security, can at most serve as a tie-breaker between economically indistinguishable investment options.

But as Cerulli explains, more retirement plan sponsors are linking the long-term nature of their participants’ investing interests with the growing importance and materiality of ESG factors. A given retirement plans’ termination date often extends far into the future, if one is set at all, so it becomes challenging to assess whether long-term problems like climate change or water scarcity should factor into investing decisions made in the short-term.

Whatever the case, many asset managers have witnessed a moderate (65%) or significant (13%) increase in demand among clients and prospects for a written commitment to The United Nations-supported Principles for Responsible Investment (UNPRI) Initiative. As Cerulli explains, UNPRI Initiative signatories pledge to implement a list of best practices for responsible investing.

Cerulli says some asset managers are even employing ESG capabilities, and their UNPRI signatory status, as a differentiator when presenting their approach to managing risk, generating returns, or both.

Looking to the portfolio building process, many managers anticipate that the greatest growth potential for ESG among asset classes will be in U.S. equity (78%) and international equity (74%). Several factors shape this view of asset class potential, Cerulli says. For instance, U.S. equity and international equity are among the most commoditized asset classes—so ESG can be a valuable differentiating factor.

Cerulli observes that private equity and other alternative investments, such as real estate, operate with greater flexibility and are bound by fewer liquidity constraints than highly regulated vehicles. This allows alternatives managers to invest directly in unlisted companies to facilitate impact investing or other ESG factors, such as shareholder advocacy.

Even with new attention, Cerulli is quick to add that only about 26% of managers say they receive frequent questions from institutional clients about ESG issues. Another 32% say they have received a small number of queries during recent sales or client relationship management efforts, while 42% have seen little or no client attention being paid directly to ESG.

Perhaps for this reason, only about 17% of asset managers say ESG is already very important. Another 78% say it is somewhat important, leaving just 4% neutral on the importance of ESG.

More information about how to obtain the full Cerulli analysis of ESG investing, contained in the August 2014 issue of “The Cerulli Edge – U.S. Monthly Product Trends,” is available here.