Over the last decade, there has been a rapid increase in the integration of environmental, social and governance (ESG) factors into the investment decisions of institutional investors.
Three main themes have driven this massive shift of assets:1) Many investors are motivated by non-financial reasons to tilt their portfolios toward firms with strong ESG criteria; 2) Others are incorporating ESG factors into portfolios because they believe them to be linked to financial performance; and 3) believe that tilting their portfolios toward “green” companies, and away from “brown” or “sin” companies, reduces not only environmental risks but also risks of fraud (green companies have stronger risk controls), human rights scandals, consumer boycotts, regulatory risk and lawsuits.
Joseph McCahery, Paul Pudschedl and Martin Steindl, authors of the October 2022 paper “Institutional Investors, Alternative Asset Managers, and ESG Preferences,” surveyed institutional investors to understand why they integrate ESG factors into their investment management processes. The authors’ data sample is from a 2020 survey of 106 U.K., European and North American institutions, as well as a small percentage of respondents around the world, who were currently investing in private equity and venture capital. They asked investors about their motivations for considering ESG factors, the relative importance of ESG criteria, their use in relation to risk and return considerations, how often ESG criteria are considered and in which stages of the portfolio management process, and for which screening or evaluative purposes ESG criteria are employed. Here is a summary of their findings:
U.S. funds overall used ESG less intensively than U.K. funds, and both used it less intensively than continental European funds. Forty-eight percent of institutional investors on average rated investment riskiness as their first or second important reason for considering ESG; 45% rated an ESG mandate as first or second in importance; and only 13% considered ESG investing for diversification purposes. When evaluating individual components of ESG scores, institutional investors considered the governance score the most important component—because it reduces the risks of a left-tail event—followed by E and then S.
While general partners were motivated to integrate ESG factors into their investment strategies in response to increased client demand for sustainable products, limited partners were motivated to incorporate ESG because they believe that ESG usage is more strongly correlated with financial performance (both risk and return). While LPs also would address ESG concerns about a particular company with a GP, that was only for egregious concerns—LPs did not have the same significant effect on governance that GPs had.
Private equity used ESG factors more intensely than venture capital. PE firms (typically investors in later-stage companies, like with leveraged buyouts) used voice and exit strategies more extensively than VC funds (typically investors in startups and early-stage companies) in efforts to promote ESG activities in companies. These results were consistent with findings that investors with longer-term horizons engage more with the ESG quality of companies in their portfolios.
Investor takeaways
The good news for ESG investors tilting their portfolios to green companies is that huge cash flows are providing companies with a strong positive incentive to invest in ESG by lowering their cost of capital. Simultaneously, these same cash flows are raising the cost of capital of firms with negative ratings, which may ultimately influence those firms to do more. The cash flows also seem to be the reason that asset-manager proxy voting support for ESG-related shareholder resolutions across 50 large fund families increased considerably, with average support in 2020 rising to 46% from only 27% in 2015.
While ESG investing continues to gain adherents, the absence of comparable data, nonetheless, presents a major hurdle for examining firms’ ESG factors. Solving this problem likely would lead to greater allocations to ESG strategies.
Larry Swedroe is the head of financial and economic research at Buckingham Wealth Partners. He has authored or co-authored 18 books on investing. His latest is “Your Essential Guide to Sustainable Investing.” All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. LSR-22-409