Over the past year, I’ve interviewed some 70 executives in the investment management sector, from large pension funds in the U.S., Europe, and Asia to asset managers like BlackRock, Vanguard, and State Street. My conversations with CEOs, Chief Investment Officers, senior portfolio managers, and others confirmed how mainstream sustainable investing has become—and also that investors now have a mind-boggling array of flavors of sustainable from which to choose.
That means individual investors need a clearer understanding of the different sustainable investing strategies being employed today. Each of them has its own risks and benefits and an investor needs to determine they fit with her or her own investment objectives. Although terms like “impact investing” or “ESG (environmental, social, and governance)” are often used as synonyms, there are important nuances. Investors who buy what are claimed to be sustainable investment products should understand which of these strategies are being used. If they cannot, they should be wary of “green washing.”
A useful classification system has been developed by Eurosif and is presented in their latest report. It describes seven strategies and their growth rates.
The largest one in terms of assets under management (AUM), although slightly declining (negative 3% compound annual growth rate or CAGR) due to its simplistic nature and the growth of other strategies, is exclusions. This strategy isn’t that far from the origins of sustainable investing in the “Socially Responsible Investing (SRI)” movement of the early 1980s. These values-based mutual funds screened out undesirable industries (such as alcohol, munitions, and tobacco) and companies (such as those with human rights violations). The choice was basically a binary one. A company is in or out based on its sector or a certain attribute of the company.
Today’s approach is basically a more sophisticated type of negative screening which allows for gradations of “bad,” like percentage of sales in a sector and choices about the cut-off point for exclusion on poor ESG performance, although ones with poor performance where there are indications of a positive trend may not end up being excluded. While a relatively simple strategy to implement, choices have to be made about which industries to exclude. This typically involves some combination of values and value considerations, where the line between them can blur. For example, tobacco is typically excluded for moral reasons but some are also convinced that the market cap of these companies will drop if smoking declines. Similarly, those who divest oil & gas companies want to send a signal but are also concerned that as renewable energy grows, these companies will have substantial stranded assets.
The next largest strategy, with a CAGR of 7%, is engagement and voting. This is the conceptual opposite of exclusions. Instead of screening out companies, the investor engages with them in various ways, including proxy voting, to change their behavior. This can be to get them to improve on a critical ESG issue, such as overuse of iPhones by young children, as Jana Partners and CalSTRS have done with Apple, or to transform their very business model, like moving a coal-based utility company to renewable energy, as ValueAct has done with AES. Adoption of this approach has been somewhat lumpy by sector: while many large investors are engaging with oil & gas companies to become non-fossil fuel-based energy companies, few if any are engaging with tobacco companies even though some, such as PMI, are actively working to replace cigarettes with less harmful alternatives.
ESG integration is the third-largest strategy and the one growing most rapidly with a CAGR of 27%. It’s rapid growth reflects how ESG is simply becoming another factor in investing, joining such traditional ones as value, momentum, volatility, and quality. This is a much more sophisticated strategy than negative screening, although exclusions can be a part of it. In ESG integration, portfolio managers take account of the material ESG factors in a company’s industry (i.e., those critical to their industry, like product safety to a pharma company), such as taking guidance from the Sustainability Accounting Standards Board (of which I was founding chairman), and build them into their fundamental financial analysis. One of the big challenges here is getting accurate ESG data, although this is improving and new sources are emerging based on AI and big data technologies, such as developed by TruValue Labs. ESG integration is being used across all asset classes (equity, fixed income, and real assets) and promises to become core to all investing. It is also sometimes combined with engagement and proxy voting, such as when portfolio managers start asking the CEO and CFO about material sustainability issues.
The next-largest strategy is norm-based screening, but this is a rapidly declining one with a negative 21% CAGR. Like exclusions, it is a very simple strategy which simply involves excluding companies that haven’t committed to and aren’t practicing globally established norms, such as those of the U.N. Global Compact with its 10 principles regarding the environment, labor, human rights, and anticorruption. The difference between this strategy and exclusions is that the latter is based on choices made by the investor, whereas in norm-based screening the investor simply takes some external sources as authoritative on defining what is a sustainable company. Its rapid decline is due to its simplicity but also to the lack of empirical evidence that companies which adhere to some set of norms have better performance over the long-term.
The three smallest strategies, from largest to smallest, are best-in-class (9% CAGR), sustainability-themed (1% CAGR), and impact investing (5% CAGR). Best-in-class strategies select companies that are performing particularly well on relevant ESG issues, either in general or within an industry. Unlike ESG integration which focuses on a company’s performance on industry-specific material issues, this strategy is based on some overall sustainability rating of the company. Sustainability-themed strategies are focused on companies developing solutions to societal challenges, such as renewable energy to combat climate change or financial services for the poor.
Impact investing is the most complicated one to describe. Historically it has been small investments in private markets with rigorous criteria such as “additionality” and “intentionality” and it is this definition that still applies for describing this strategy. However, the term is now being used by large investors in the public markets. It is focused on companies whose products and services are making a net positive contribution to society while still earning a market return, such as seen through the lens of the U.N.’s Sustainable Development Goals. As with ESG integration, there are data challenges in determining the positive and negative impacts of a company’s products and services. This is being addressed by the Impact Management Project, a structured network of a diverse group of organizations all working on impact measurement and reporting.
As criteria get developed for what “impact” means in the public markets, the meaning of impact investing will become broader and the amount of assets being classified according to this strategy could grow significantly. My own view is that over time impact investing, ESG integration, and engagement will become the dominant strategies, and will often be used in combination. Longer term, these will become factors in investing in general. When this happens, no doubt the frontier of sustainable investing will move forward with newer strategies.
We’ve come a long way from the days of blunt-instrument SRI strategies of the 1980s, where empirical evidence of positive returns was inconclusive. Today, a growing number of academic studies have shown that companies which perform well on material sustainability issues have superior financial performance. And investors recognize this: in 2018, according to a recent US SIF report, a total of $12.0 trillion in assets under management (AUM) were being managed with sustainable investing strategies—approximately 26% of U.S.-domiciled AUM. This is up from $8.7 trillion in 2016, a 38% increase.
“Sustainable investing” has always been values-based, but today, it’s a much broader category—and is also value-based.
Robert G. Eccles is Visiting Professor of Management Practice at Saïd Business School, University of Oxford.