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Investors concerned about climate change, gender inequality and a range of other issues now have access to more data and information about the risks and potential rewards of sustainable investing
WHEN TALK TURNS TO INVESTING these days, it’s possible that you’ll hear the term “sustainable and impact investing.” There’s a reason for that: The approach – often described as “investing with the goal of benefiting people, the planet and portfolios” – has been on a tear.
That’s certainly reflected in the volume of assets the approach has attracted. Investments in sustainability funds totaled more than $30 trillion in 2018,1 up from essentially zero 25 years ago.2 Last year alone, inflows into funds that take environmental, social and governance (ESG) data into consideration quadrupled, rising from $5 billion in 2018 to $20 billion in 2019.3
Much of this growth is due to the expanding array of choices investors now have to access investments with a sustainable and impact investing focus. In addition to individual equities, there are green bonds, exchange-traded funds (ETFs), index-linked funds, and many more.
And while sustainable investing is gaining traction among a wide range of investors, women, high-net-worth individuals and especially millennials appear to be at the forefront of the movement.4 Based on these demographic trends, the momentum should only continue to build well into the future. For example, BofA Global Research estimates that inflows into sustainable strategies could be roughly $15 trillion to $20 trillion over the next few decades.5
What’s behind this broad expansion? Here are some of the factors as we see them.
Investing in what matters most to you …
These days we’re all more aware of critical issues facing humanity: health care, how employers are providing safe and secure working environments and benefits like paid leave to name a few. Investors may be looking for companies that are taking steps to find solutions to these types of challenges—such as reducing their carbon footprint or expanding the diversity of their board—while avoiding or divesting from those that are not. In this way, investors can honor their concerns, in effect aligning their portfolios with their personal values.
… while also focusing on potential returns
In a stark contrast to the recent past, when values-based investors might have expected lower returns, we have seen ample evidence7 that corporations scoring high on an “ESG scorecard” may perform as well as or even better than the broader market.
This can help make investing sustainably seem like a clear choice. Or, as Jackie VanderBrug, head of Sustainable and Impact Investment Strategy in the Chief Investment Office for Merrill and Bank of America Private Bank, puts it, “If all things are equal in terms of risk and returns, the real question investors might ask is, Why not add a sustainability lens to your portfolio and invest in companies that are potentially poised for longer-term success?”
"Looking at a company’s ESG factors may also help investors spot potential problem areas—and understand their consequences. They can then use that information to help manage risk in their portfolios.”
head of CIO Due Diligence in the Chief Investment Office for Merrill and Bank of America Private Bank
…and keeping an eye on risk
According to Anna Snider, head of Due Diligence in the Chief Investment Office for Merrill and Bank of America Private Bank, “Looking at a company’s ESG data may also help investors spot potential problem areas — and understand their consequences. They can then use that information to help manage risk in their portfolios.” But what would they look for? If a company is failing to provide secure conditions for their employees they may not be able to operate due to safety concerns. A corporation that’s neglecting to address gender inequality in the executive suite may be sued by employees. Poor quality control may lead to a defect that prompts consumers to avoid a company’s products and investors to avoid its stock.
Understanding these issues of ESG mismanagement is important as they may lead to a decline in asset value—including a company’s share price. MSCI ESG Research identified that companies in the bottom fifth of the MSCI World Index, based on ESG rankings, experienced large drawdowns (above 95%) three times more often than those in the top fifth during the period from January 2007 to May 2017. (See chart below)
The MSCI Foundations of ESG Investing study looks at correlation between ESG rating and financial risk over a period of time. To assess the ability of companies’ risk management functions to successfully mitigate severe incidents that can lead to financial losses, the study looked at the frequency of large, adverse idiosyncratic stock price moves. To be precise, for the 10-year observation period (2007-2017), they identified companies in the MSCI World Index that have had a drawdown of more than 95% or went bankrupt in that 3-year period after the company was categorized in either the top or bottom ESG rating quintile. For each of these incidents, they looked at each company’s ESG rating before the respective 3-year drawdown period started. Over the 10-year period of 2007-2017, higher ESG-rated companies at that time period showed a lower frequency of idiosyncratic risk incidents, suggesting that high ESG-rated companies were better at mitigating serious business risks.
This study validates the three transmission channels using MSCI ESG Ratings for the MSCI World Index universe for the January 2007 to May 2017 time period. The universe contains over 1,600 stocks and is therefore sufficiently diversified for the statistical analysis performed for this time period. All risk and factor calculations are performed using the Barra Long-Term Global Equity Model (GEMLT). Note: These outcomes may differ when market experiences volatility or downturns.
Of course, not all mismanagement issues are foreseeable – and they rarely unfold at the same rate. A database hack, for example, might happen quickly and, once revealed by a company, may drag its stock price down just as fast. Other issues may take years to be recognized, or at least acknowledged, as with coal and carbon emissions.
Coal-fired power plants have long been known to emit large volumes of carbon dioxide and other pollutants. Yet it was only as the connection between atmospheric carbon and climate change became clearer – or was more broadly acknowledged – that individual and institutional investors grew concerned enough to consider divesting the hydrocarbon.
"If all things are equal in terms of risk and returns, the real question investors might ask is, ‘Why not add a sustainability lens to your portfolio and invest in companies that are potentially poised for longer-term success?”
head of Sustainable and Impact Investment Strategy in the Chief Investment Office for Merrill and Bank of America Private Bank
Eventually, more and more of them did divest, and a kind of tipping point was reached. We’ve seen this result in a lower credit rating for the sector and a full recovery seems unlikely, at least at this point.6
Corporate reporting has expanded
In another major shift, more and more companies are releasing ESG-related information – on waste management, diversity and inclusion, raw materials sourcing, and the like. There is not yet a set of guidelines that regulate the kind of data companies should report, but corporate transparency has improved substantially in recent years, allowing investors and independent rating agencies to form increasingly reliable views about the risks and opportunities associated with ESG issues and their eﬀect on company performance.
How you can learn more
Sustainable investing has evolved substantially over the past decade, and more investors are realizing the potential it offers to match market returns while also helping to mitigate risks. At the same time, more companies are getting on the bandwagon and are making data available on their environmental, social and governance record, with much of it compiled and checked by independent third parties. We believe this evolution makes sustainable investing compelling to consider. For more information, read our report “Performance Realities: Revisited,” and speak to your advisor about whether this approach makes sense for you.
4 Among respondents in the 2018 U.S. Trust Wealth and WorthTM, 47% of women, 49% of high net worth individuals and 79% of millennials said they were interested in owning or already owned ESG investments.
6 Coal industry stocks overall lost a quarter of their value in 2019, dropping from around $100 to $75 in the 12 month period, and fell further, to around $65, in the first two months of 2020. Tradingeconomics.com, 2020.
This material does not take into account a client's particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security or investment strategy. Merrill offers a broad range of brokerage, investment advisory (including financial planning) and other services. There are important differences between brokerage and investment advisory services, including the type of advice and assistance provided, the fees charged, and the rights and obligations of the parties. It is important to understand the differences, particularly when determining which service or services to select. For more information about these services and their differences, speak with your Merrill financial advisor.
Investing involves risk, including the possible loss of principal. Past performance is no guarantee of future results.
The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for Global Wealth and Investment Management ("GWIM") clients, is part of the Investment Solutions Group of GWIM, a division of Bank of America Corporation (“BofA Corp.”).
BofA Global Research is research produced by BofA Securities, Inc. (“BofAS”) and/or one or more of its affiliates. BofAS is a registered broker-dealer, Member SIPC, and wholly owned subsidiary of Bank of America Corporation.
Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.
Investments mentioned are subject to market volatility and the risks of their underlying securities; this applies to equity and fixed income securities. In addition, each has its own specific risk profile and investment strategies detailed in its prospectus or other offering material.