As the world grapples with major social, economic, and political issues, ESG (environmental, social and governance) has become the ubiquitous acronym under which investors, financial institutions, corporations, and public policy entities develop guidelines and procedures to address these challenges.

ESG encompasses climate change, global health crises, poverty, diversity, business ethics, and many other issues. The complexity of these issues, and the differing perspectives of multiple constituencies, requires investment managers to be thoughtful and balanced in refocusing their investment processes and decisions.

As with any sound investment approach, it also requires flexibility, openness, and a commitment to continually incorporate new information and analysis in making long-term investment decisions.

There is no single best approach in addressing the challenges discussed above. ESG investing approaches cover a broad spectrum, with stringent exclusionary policies or negative screening at one end of the spectrum, and proactive, targeted impact investing on the other. In between these two extremes is a wide range of approaches to integrating ESG investing policies and strategies including hybrid approaches which seek to balance exclusions with ESG optimization in managing investment portfolios.  Whatever approach to ESG investing a firm undertakes, it must continue to manage client assets in compliance with applicable regulations.

Investor interest in ESG has been rising rapidly, with annual inflows into ESG-oriented funds climbing from $5 billion in 2018, to $21 billion in 2019, to $51 billion in 2020, according to Morningstar.ⁱ  At the end of 2020, ESG-oriented funds held $236 billion in total assets, which represented a remarkable one-year increase of 70%, bolstered both by the rising influx of new investment dollars and by strong market performance.

That growing interest has incentivized mutual fund companies to launch new ESG-related funds or repurpose existing funds at a rapid pace. A record 71 ESG-oriented funds were launched in 2020 – nearly double the previous annual record of 44 in 2017 – to bring the total to 392 funds at the end of 2020.ⁱⁱ

Breaking down ESG

While ESG stands for “environmental, social and governance,” how do these elements play into corporate policies and procedures?

Environmental

The environmental aspect takes into account both the positive and negative environmental impact of a company’s operation. A company may rate well if it has sound policies and measurable actions regarding climate change, greenhouse gas emissions, carbon footprint, water conservation, renewable energy, waste disposal, green products and technology, and environmental benefits for its employees. But a company with products or policies that are detrimental to the environment would likely score poorly in this category.

Social

The social component relates to issues such as company culture and treatment and training of employees, hiring practices, diversity, and relationships with customers, consumers, and suppliers.

(Corporate) governance

Governance involves areas such as executive compensation, policies and diversity of the board of directors, company oversight, and shareholder relations.

“Greenwashing” brings added scrutiny

With the rising interest in ESG has come increased scrutiny over the investment management industry’s ESG processes, research commitment, and, ultimately, portfolio construction. One aspect of this scrutiny is to ensure that investment management firms or mutual funds that purport to offer ESG strategies are true to that objective, and not just using ESG as a marketing tactic to increase assets under management – otherwise known as “greenwashing.”

Industry regulators, including the SEC, have been active in issuing statements and observations related to ESG processes and disclosures. This type of activity is expected to continue and likely increase with the rise in investor interest in ESG, the pace of ESG developments, and ongoing debate about whether there could be improved standards to compare practices among firms. Additionally, consulting firms and ratings firms have come out with opinions and guidance around this topic.

Are there investment benefits to ESG?

While ESG has taken root due, in part, to changing industry dynamics, its emergence has also contributed to those changing dynamics.  This suggests that there may be opportunities for alpha generation when investing through an ESG lens.

For example, firms that address issues like climate change may be disrupting entire industries, like transportation. Consider the growth of electric vehicles as a case in point. This growth may encourage asset managers to evaluate the impact of electric vehicles on the entire value chain in search of opportunities. Companies in virtually any industry may also be employing capital to projects addressing ESG issues material to their business, which could create long-term value for shareholders and other stakeholders.

Incorporating ESG analysis is another dimension of risk management utilized while pursuing the optimization of client returns. It is this “middle ground” of ESG risk management where many large financial institutions, including Thrivent Asset Management, LLC (TAM), have begun to direct their focus.

For more information on ESG and TAM, please read “Thrivent Asset Management’s approach to ESG investing.”