By: Jake Willms, Quantitative Analyst
Environmental, Social, and Governance investing, or “ESG” for short, is a developing topic within the finance community as of late. Just last week, the United States Department of Labor (DOL) proposed a new rule that if passed would add five core additions to its ESG investing regulations, harshly limiting the ability for most employee’s to select investments based on ESG factors.
ESG is best understood as a “win-win” investment approach for those who seek it. Investing your money to generate return (win) and supporting environmental, social, or governance causes you believe in (win). Generally, investors are expected to accept some level of underperformance in exchange for investing in ESG causes, but what if that isn’t always the case?
Larry Fink, the CEO of Blackrock, announced a surprising commitment to ESG principles at the beginning of the year. “Our investment conviction is that sustainability and climate-integrated portfolios can provide better risk-adjusted returns to investors, and with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward.”
Fink proposes a counterpoint to the traditional understanding of ESG investing, suggesting that ESG investing principles may soon be comparable to long-standing pillars of the financial industry such as value and momentum. Could ESG be moving away from an expected loss in performance and push closer to being a true “win-win” investment strategy?
There are a few challenges to consider. First, recognize that ESG is a combination of environmental, social, and governance causes. Depending on your objectives and interests, one or more of these categories may stand out to you. In short, ESG means different things to different people, and according to the CFA Institute, investors are moving faster in incorporating governance into their investment portfolios than the other two. Moreover, there are limitations to available ESG data and integration within fixed income markets that is slowing down progress. And, with the lack of an “ESG reporting standard”, as the CFA Institute calls it, it’s hard to be optimistic for improvements to data collection and availability.
In short, ESG is an investment topic that will be sure to continue striking up controversy and perhaps influence the way managers approach their portfolios in the short-term. Whether it will reach the status of long-standing principles like value and momentum, however, remains to be seen. One thing is for sure though: ESG’s return tradeoff may be gone sooner rather than later.