SustainaWeekly - Majority of funds do not incorporate ESG into investment decisions
With the growing importance of ESG, we take a closer look whether indeed investors are incorporating ESG considerations into investment strategies and if yes, how. We show that while the majority of investors incorporate ESG, that is not true when looking at Assets under Management (AuM), implying that a lot of funds within an asset manager do not integrate their own ESG assessment frameworks. This could be due to the passive approach of some funds, which makes ESG integration potentially harder. While also fear that returns will be hampered could be seen as a potential reason, we do not believe this is in reality in a fact. For investors that incorporate ESG, the most common strategies are ESG integration and stewardship. We also see a growing number of investors focused on the decarbonization pathway of their portfolios.
Do investors incorporate ESG into investment decisions?
A recent survey by global data provider FTSE Russell (see ) indicates that 88% of the asset owners implement sustainable investment strategies. That is a whooping 35 percentage points increase compared to 2018. That is in line with another finding of the survey, that shows that investors see climate issues now as “business as usual”: all respondents have indicated that they are concerned with the investment impact of climate risks into their portfolios. One might therefore say that ESG is now a “must” input when assessing investment decisions, but that might not necessarily be the case.
Another survey by Morningstar, the financial services firm that provides research on firm behaviour, shows that actually when it comes to assets under management (AuM), the story is a bit different. The firm concludes that most investors (71%) indicate that less than half of their organization’s total AuM takes into account ESG considerations (see ). That is despite the fact that 85% have said that they see ESG as material (risk) to their overall portfolio, with also around 50% saying it is “very material”.
That allows us to conclude the following: while investors see ESG as a key risk to their portfolio, and have themselves either developed or adopted strategies to integrate ESG into investment decisions, not all of their funds (in fact actually, a majority of their AuM) is not following them.
One potential explanation for this could be due to the fact that a big chunk of the investors’ funds are usually placed in more passive strategies, such as index tracking. And indeed, around 60% of the largest global investors (that is, with AuM above USD 10bn) seem to have more than a fifth of their portfolio allocated to index strategies. Looking at passive investments in general, this figure can be even higher, with for example around 30% of AuM of mutual funds allocated to passive investments according to PwC. It is harder to incorporate ESG in passive strategies, as funds are usually committed to follow a certain benchmark, which may or may not be ESG-focused. Hence, even though an investor might have developed an ESG framework internally, it may not be applicable for its passive investments.
We use ETFs as proxy for passive investments as the majority tends to be have a passive strategy (around 95-98% of US ETFs are labelled as “passive”, see ) and based on that, we try to estimate how many of those follow an ESG strategy. From the Fixed Income ETFs in Europe that fall under the Sustainable Finance Disclosure Regulation (SFDR), only around 30% has been classified as either Article 8 or 9 (light or dark green funds, respectively). That compares to around 45% of all non-ETFs Fixed Income funds out there. Looking at AuM makes that share even smaller, with only around 15% of the ETF’s AuM being to some extent focused on ESG.
Morningstar also sees the (negative) impact on returns as one of the reasons of why ESG strategies are not being pursued, with almost 40% of investors citing this as one of the barriers to ESG implementation. This could therefore be another reason of why ESG strategies appear not to being applied to all of an investor’s funds. The same survey finds that 16% of investors also see their organizations’ approach to ESG as hampering financial returns.
We have previously argued (see ) that while ESG-friendly companies might at the moment fail to deliver good returns, ESG strategies tend to outperform in the long-term. We have also previously shown (see ) that companies with better ESG credentials (proxied by the Sustainalytics ESG risk rating) have a statistically significant effect on corporate bond pricing, i.e. better ESG credentials result in lower credit spreads. But is that also the case in practice?
A PwC survey (see ) has shown that 60% of investors said they record higher returns on their ESG investments compared to non-ESG ones, and only 14% mentioned they actually had a negative impact on returns. Also more than half has mentioned it took less than 3 years for these better returns to materialize. We therefore do not believe that the perceived negative impact on returns should be seen as a real barrier to implement ESG strategies. While investments returns may be impacted by market nuisances in the short-term, in the long-term, those tend to yield better returns.
How is ESG being incorporated into investment decisions?
We now take a closer look at how investors are currently integrating ESG into investment decisions. The FTSE Russell survey indicates that for Fixed Income investors, the most common ESG strategies pursued are (i) stewardship (40%), which involves actively engaging with the company in order to drive positive changes related to ESG, and (ii) the thematic / impact investing (35%). Within equities, however, most investors integrate ESG in the form of (i) ESG integration (61%), which involves incorporating material ESG factors (risks and opportunities) that are likely to affect a company’s operation and performance into traditional fundamental analysis, and (ii) stewardship (54%). Overall, therefore, we can say that on average the mostly used strategies are ESG integration and stewardship.
The same survey also shows that only 24% of investors currently include climate/sustainability factors into their Strategic Asset Allocation (SAA) models or frameworks (although 44% mentions they are currently considering internally how to do so). The survey also shows that only 4% says they do not incorporate sustainability within SAA models / frameworks, but are also not working on doing so, and that is compared to 24% last year. Therefore, clearly ESG incorporation has been spreading over the years.
Interestingly, a survey by State Street Global Advisors (see ) has shown that most of the investors (46%) manage portfolios against Paris-Aligned Benchmarks. That is, they have a clear focus on the climate / carbon footprint of their portfolios and aim to decarbonize them at a pace aligned with the Paris Agreement. The use of science-based transition targets for the portfolio are also mentioned to be used by 34% of the respondents. This aligns well with findings from our own survey (see ), which shows that investors are increasingly taking into account decarbonization pathways and/or targets from issuers when analysing ESG instruments.
In terms of data used for ESG incorporation, Morningstar’s survey shows that most of the respondents use proxy advisors (32%), which matches with the fact that a lot of investors use stewardship as ESG strategies. However, the survey also shows that investors use ESG data providers (29%), investment consultants (28%) and ESG rating providers (28%). These can be applied for either screening policies (for example, by directly excluding a company that does not satisfy a certain ESG risk rating) or for ESG integration, where the data provided by external sources can be, for example, integrated into materiality assessment and/or ESG scorecards. We think the latter is usually the case, not only because we previously demonstrated that ESG integration is more frequently used than screening as an investment strategy, but also because our own survey has previously indicated that the majority of investors use ESG risk ratings for their own analysis, rather than as a “blind” input.
