Despite what “popular wisdom” may believe, there is a growing body of independent research validating that ESG (Environmental, Social and Governance) considerations and sustainable investing goals are not detrimental to long-term investment performance and may even enhance returns or mitigate risk. This memo shares a sampling of recent articles on a variety of SRI investing topics, including ESG integration, risk mitigation, climate change, and impact investing as well as our viewpoint on the points discussed. These articles help demonstrate how much this area of the investment industry has grown and advanced in recent years.
We are happy to elaborate on any of the articles referenced below, as we have only included a short synopsis of our viewpoint on each article.
George Serafeim and Adam Seesel, Barron’s – June 23, 2018
Article excerpts/summary: “Here’s what ESG integration is really about: From an investor’s standpoint, a sustainable company is one positioned for long-term success, one whose management understands and addresses short-term risks and innovates to exploit long-term opportunities. ESG data are a means that can enable an investor to understand a company’s strategy, corporate purpose, and management quality, at scale and in an unbiased, quantifiable way.”
This article considers the potential for better performance using ESG integration, with consideration of the positive and negative arguments around sustainable investing. On the positive side, the argument is made that ESG integration can help investors evaluate how well a company is positioned for the changing environment in which it operates. This may include how well a company’s long-term strategy addresses the need to adapt to risks such as climate change, data privacy or increases in the productivity of its workforce, thus helping investors to identify investments that will perform better over the longer term.
The negative side of the debate over ESG integration argues that placing restrictions on the choices available to an investor will naturally inhibit performance, and it is too difficult to standardize ESG factors to the point that makes them materially useful in the investment process.
Source: Barron’s, 6/23/18, Does Sustainable Investing Lead to Lower Returns?
Cambridge Trust Viewpoint: ESG integration is a part of our investment process for the SRI strategies, helping us to identify companies that we feel have the potential to outperform, from both a fundamental and sustainability perspective. We agree with the perspective that a sustainable company is well-positioned for long-term success, and ESG and non-financial research can help to identify company-specific risks beyond traditional fundamental research. We disagree with the negative viewpoint that narrowing the universe inhibits the ability to achieve strong long-term performance; Cambridge Trust’s proprietary SRI strategy has meaningfully outperformed relevant market benchmarks since its inception in 2014. We agree that data can be challenging to standardize. For this reason, we conduct our own research in-house and analyze inputs on a company- specific basis without relying solely on external research providers like many passively managed SRI index funds do.
Rachel Evans, Bloomberg – December 18, 2018
Article excerpts/summary: As sustainable investing and ESG integration has moved into the mainstream, the rush to capture assets has caused some money managers to roll out higher fee products sold as “ethical”, but these products are not highly differentiated from broad market indices. They often only loosely define ESG or, in our view, have a hurdle for inclusion that is too low. Frequently, funds employ an approach where they invest in the “best” companies in the “worst” sectors (in order to stay generally aligned with a market index), but this allows exposures in the tobacco, oil and defense industries that might not be the intention of the investor/client.
“Fund managers use different rules made by different index compilers, all of which can lead to radically different assessments for the same company. Lower emissions or a good safety record may win over millennials worried about environmental or social issues. However, institutions might reward a company simply for good governance—even in an industry like oil production.”
Source: Bloomberg Businessweek, 12/18/18, How Socially Responsible Investing Lost its Soul
Cambridge Trust Viewpoint: We agree with the author and believe that many SRI funds own companies with weak sustainability practices. Because of the wide dispersion of sustainability funds marketed today, an investor needs to peel back the onion to understand which companies are actually owned by the portfolio manager. As an example, Bloomberg found that Facebook was included in the top ten holdings of 80 socially responsible funds, despite their well-known governance and data privacy issues (Facebook Turns Toxic for Some ESG Fund, March 26, 2018, Bloomberg). We have found that our inclusion threshold for companies is higher than many other managers and mutual funds as they hold positions that we would not purchase. Unlike others, we are willing to be underweight or even zero-weight in a sector in order to avoid companies involved in practices that are not sustainable. Additionally, we use the same fee schedules for clients using our SRI strategy.
Jeremy Grantham, Co-Founder, Grantham Foundation for the Protection of the Environment -- June 13, 2018
Article excerpts/summary: It has long been thought that one of the perils of SRI is the avoidance of certain industries, such as fossil fuels, and the potential effect on performance in times when those industries are outperforming. In order to either dispel or prove the theory that outright avoidance leads to underperformance, the Grantham Foundation looked at how the S&P 500 index performed over time if each major sector was removed. Going back in history, starting in 1925, 1957 and 1989, they found that there was a difference of only 0.5-0.6% between the best and worst returns when any one sector was removed during those time periods.
“What does this mean for divestment? It means that if investors take out fossil fuel companies from their portfolios, their starting assumption should not be that you have destroyed the value.”
Source: The London School of Economics and Political Science/Grantham Research Institute on Climate Change and the Environment, 6/13/18, The Mythical Peril of Divesting from Fossil Fuels
Cambridge Trust Viewpoint: Cambridge Trust’s SRI strategy currently has no direct holdings in the energy sector in order to avoid companies exposed to fracking. We have found that lack of exposure to any one sector has not had a meaningful impact on our longer term performance. As part of our research process, we are consistently evaluating renewable and sustainable energy names with the intention to add positions when we find investments appropriate for the SRI strategy on both a fundamental valuation and ESG basis.
Jeroen Bos, CFA, CFA Institute -- September 28, 2018
Article excerpts/summary: “Positive impact can lead to more sustainable long-term business models, supporting valuations and risk-return characteristics of investment portfolios.”
Questions asked to gauge impact include how an investment benefits society, CO2 emissions, global warming, water efficiency, and contribution to the United Nations Sustainable Development Goals. Considerations of these factors can lead to better, more comprehensive investment decisions.
Source: CFA Institute Magazine, 9/28/18, How Should Investors Measure the Societal Impact of Investing?
Cambridge Trust Viewpoint: We look for investments that are positively impactful (as a step beyond simply excluding investments with negative impact).
Clermont Partners -- May 31, 2018
Article excerpts/summary: “Mainstream portfolio managers weren’t typically looking at it (potential investments) from a social responsibility ‘do-gooder’ angle. Instead, they had vague fears that the lack of ESG focus within portfolio companies might actually pose increased business risk. As a result, attention has shifted to using ESG screens to enhance the investment process, otherwise known as ‘ESG integration,’ to mitigate investment risk.”
Top ESG factors to consider include culture, data security and the environment. Happier, more engaged employees can reduce the cost of doing business and increase productivity. Data security poses a major risk for many industries. Environmental issues represent future liabilities in all industries.
Source: Clermont Partners, 5/31/18, Growth of ESG Integration Sparked by Risk Mitigation and Client Demand
Cambridge Trust Viewpoint: We consider ESG factors to be leading indicators of potential portfolio risks. We place an emphasis on factors such as employee and community engagement in our research process. Data privacy and security are important issues to consider as well.
Usman Hayat, CFA, Market Integrity Insights -- November 19, 2015
Article excerpts/summary: Will the consideration of ESG issues lead to more complete investment research and better informed decisions? Was it possible to know the ESG risks posed by Volkswagen prior to the emissions scandal? Were there any red flags with BP before the 2010 oil spill in the Gulf of Mexico?
The analysis of ESG issues is not new and should be a complement to traditional fundamental analysis for both equities and fixed income. Companies that incorporate ESG factors into strategic planning provide a clearer picture to investors.
Source: CFA Institute, 11/19/15, ESG Education: Bridging the Gap for Better Informed Investment Decisions
Cambridge Trust Viewpoint: We feel that the inclusion of ESG factors in the investment decision-making process allows for a more complete picture of a company. For example, we did not invest in Wells Fargo due to a past history of mortgage-related issues, specifically because we did not feel the company had made significant progress addressing corporate governance. As a result, we did not hold positions in Wells Fargo when news of aggressive cross selling became known, which significantly impacted the stock’s performance in 2018.
FTSE Russell Annual Trends Report -- May 30, 2018
Article excerpts/summary: “There are approximately 3,000 global, listed companies with exposure to the green economy.”
A study by FTSE Russell looks at the myths of sustainable investing including the belief that the market is limited and mostly small cap companies, which sacrifices diversification. FTSE found that the sustainable or “green” market is global, large and growing. Spanning many sectors, it is well diversified and has shown outperformance versus relevant benchmark comparisons.
Source: FTSE Russell, 5/30/18, Investing in the Global Green Economy: Busting Common Myths
Cambridge Trust Viewpoint: In many publicly traded companies, we find that ESG considerations are becoming prevalent. More companies now publish Corporate Social Responsibility reports and highlight their accomplishments on their websites and in their annual reports.
Muhammed Suhail Rizwan, Asfia Obaid, Dawood Ashraf, Business & Economic Review -- November 3, 2017
Article excerpts/summary: This article looks closely at default risk, a key metric for bond investors. In a study of 1,119 non-financial firms, when risk mitigation due to corporate social responsibility efforts are considered, firms with higher levels of focus have lower rates of default. Issues related to employee engagement, product quality diversity and governance had the largest effect.
“The positive impact of ESG-related activities could be wealth enhancing and/or risk mitigating.”
Source: SSRN, Last revised: 1/22/18, The Impact of Corporate Social Responsibility on Default Risk: Empirical Evidence from US Firms
Cambridge Trust Viewpoint: We consider the level of corporate social responsibility integration into a company’s operations during our research process. Training of employees in sustainability matters is also vital for full integration. We assess whether integration is firm-wide, starting with the board and executive management, and then if it filters down to all employees and business lines.
Georg Inderst and Fiona Stewart, World Bank Group -- April 19, 2018
Article excerpts/summary: “A growing body of research shows that Environmental, Social and Governance (ESG) factors are a material credit risk for fixed income investors. The evidence suggests that incorporating ESG into fixed income investing should be part of the overall credit risk analysis and should contribute to more stable financial returns.”
Ways to incorporate ESG factors in fixed income investing include green bonds, following specific ESG indices, hiring ESG managers or including ESG across the entire investment process. The difficulties faced are a lack of standardized data and definitions as well as challenges in engagement with issuers. The demand for green bonds may also outstrip supply.
The World Bank, 4/19/18, Incorporating Environment, Social and Governance (ESG) Factors into Fixed Income Investment
Cambridge Trust Viewpoint: Many of our SRI clients have a significant portion of their portfolios invested in fixed income. We apply the same ESG research parameters to corporate bond issuers that we use for stocks. For municipal bond portfolios, we also consider the ESG compatibility of the use of proceeds of a bond issue.
We hope this sampling of some contemporary articles leads to a better understanding of how far ESG integration and sustainable investing has come in terms of becoming a mainstream idea that can help build strong, durable, and high- performing portfolios. ESG and SRI are often converging with traditional approaches to make each side of the analysis much more effective at identifying solid investment opportunities.
We believe our SRI strategies embody the best practices in ESG integration and sustainability concepts within our robust fundamental analysis framework. If you would like more information about our Sustainable & Responsible Investment strategies or sustainable investing in general, please contact your Relationship Manager.