ESG Integration is the most widely used ESG investment strategy, followed by negative/exclusionary screening
Investors are demanding that the environmental and social impact of portfolios be weighed alongside their returns, resulting in a fundamental shift in the investment management sector. As a result, the acceptance of material environmental, social and governance (ESG) characteristics as drivers of long-term investment performance is on the rise. Investors now widely expect to integrate material ESG factors into their investments and are increasingly looking for ways to define, measure and improve their total impact.
ESG investing
An ESG investment strategy encourages investors to allocate capital to companies that have a positive effect on the environment and society and are led by management teams committed to achieving related goals through prudent corporate governance practices. Environmental, social and governance (ESG) refer to the three core pillars of this investment philosophy.
ESG assets are rising globally, but it is still early days for Indian ESG-focused funds
According to the 2020 Global Sustainable Investment Review report, the global sustainable investment reached $35.3tn in 2020, representing 15% growth over 2018-20 and 55% growth over 2016-20. Sustainable investments currently account for 35.9% of professionally managed assets, worth $98.4 tn. According to this report, ESG assets could exceed $41tn by 2022, and $50tn by 2025, assuming 15% growth.
Sustainable investment assets were still growing in most regions over 2018-20, with Canada seeing the biggest increase (48% growth), followed by the US (42%), Japan (34%) and Australasia (25%). Due to the change in measurement methodology used for calculating European data for the 2020 report, European sustainable investment assets declined by 13% from 2018 to 2020.
ESG assets in Europe account for half of the global market and dominated the market until 2018. Over 2018-20, however, assets in the US (48% of total sustainable investment assets) rose by more than 40%, followed by Europe (34%), Japan (8.1%), Canada (6.9%) and Australasia (2.6%). Comparing the share of sustainable investment assets with total managed assets (2014-20), Canada had the highest proportion at 62%, followed by Europe (42%), Australasia (38%), USA (33%) and Japan (24%).
India’s investment sector has launched nine ESG-focused funds in recent years. Assets under Management (AuM) of ESG funds increased steadily, according to Morningstar data, to Rs 124.5bn (in March 2022) from Rs 22.6bn (in March 2019). In India, the proportion of ESG funds’ AuM to total AuM is 0.3%, significantly lower than in most regions.
The most popular ESG investment strategy is ESG integration
When building an ESG portfolio, there are seven key investment strategies to consider. Since ESG investing is relatively new, there are no official standards yet on how to incorporate these factors into decision making; therefore, asset managers need to choose which strategy best aligns with their investment goals. The following is a list of ESG strategies used around the world:
• ESG integration
• Corporate engagement and shareholder action
• Norms-based screening
• Negative/exclusionary screening
• Best-in-class/positive screening
• Sustainability-themed/thematic investing
• Impact and community investing
The most commonly reported sustainable investment strategy across most regions is ESG integration, according to the 2020 Global Sustainable Investment Review report, accounting for more than $25.2tn in assets. Other strategies are negative/exclusionary screening ($15.9tn), engagement/shareholder action ($10.5tn), norms-based screening ($4.1tn), sustainability-themed investing ($1.9tn), best-in-class investing (USD1.4tn) and impact/community investing ($0.3tn). There was also a change from 2018, when negative/exclusionary screening was reported as the most popular strategy for sustainable investment. The report also highlights increasing evidence that most investment organisations across regional markets employ a combination of strategies rather than relying on a single ESG investment strategy.
Following the popularity of ESG investment strategies from 2016 to 2020, sustainability-themed investing, ESG integration and corporate engagement have experienced consistent growth. However, norms-based screening, positive screening and negative screening have experienced more variable trends since 2016.
Regionally, ESG investing strategies are preferred to varying degrees. A substantial portion of assets invested in sustainability-themed investing, impact/community investing, positive/best-in-class investing and ESG integration is in the US, while Japanese investments are in corporate engagement and shareholder action, and Australasia invests in a combination of positive, negative, and norms-based screening strategies. It is worth noting, however, that European investment managers are now indirectly required to employ negative/exclusionary screening, norms-based screening and ESG integration in contrast to the past, when assets were invested following only negative/exclusionary screening and norms-based screening strategies.
To implement any of the abovementioned ESG investment strategies, investors consult third-party ESG rating agencies, including MSCI and Sustainalytics. These ESG rating agencies help investors identify material ESG risks relevant to the investee companies based on publicly available information. ESG ratings provide scores for the three material topics “E”, “S”, and “G,” as well as the overall ESG score, which investors use as a proxy for ESG performance. Those companies that score well on ESG metrics are believed to be assessing and managing ESG considerations in an appropriate manner and thinking strategically and focusing on creating long-term value. Nevertheless, investors should be careful when using ESG ratings because there is a lack of consistency among rating providers, with companies’ ESG ratings sometimes varying significantly. We recommend that investors use ESG ratings as a starting point and conduct their own second layer of analysis before investing.
The author is Assistant Director, Investment Research, Acuity Knowledge Partners
