By Michael Arone, CFA, Chief Investment Strategist, State Street Global Advisors
“Look at the world around you. It may seem like an immovable, implacable place. It is not. With the slightest push—in just the right place—it can be tipped.” ― Malcolm Gladwell, The Tipping Point: How Little Things Can Make a Big Difference
Passionate advocates of environmental, social, governance (ESG) investing have long asserted that integrating ESG attributes into portfolios is important. Plenty of notorious examples substantiate their claim. One of the greatest climate disasters in modern history, the Exxon Valdez oil spill, happened in Alaska’s Prince William Sound more than 30 years ago. Unchecked executive power and greed at Enron, WorldCom and Tyco International stained the early years of this century. More recently, the 2015 Volkswagen emissions and Wirecard accounting scandals grabbed headlines. For the ESG investing faithful, these events underscore the importance of including environmental, social and governance considerations when choosing investments.
Yet, for everyday investors, incorporating ESG attributes in portfolios has largely been a fringe benefit. Tougher regulations in response to past failures and greater ESG scrutiny by investment analysts continue to advance the ESG movement. However, a lack of clarity on ESG terminology, inconsistent data and an explosion in investment choices have created more confusion than conviction . Without a compelling reason to act, ESG investing has been easy to ignore. That is, until now.
Our new whitepaper, “ESG Investing: From Tipping Point to Turning Point,” outlines three powerful trends that we expect will drive a significant increase in ESG ETF assets this decade:
1. The Great Reset in a Turbulent 2020
In the first half of 2020, the global pandemic and protests against police brutality and racism combined to expose some very real health, social, financial and political inequities around the world. From the quiet of quarantine to the passionate protests, focusing on these struggles and injustices has provided us an opportunity to gain greater clarity about the values that are most important to each of us and our families. Strangely, despite the division emphasized in many media reports, for so many of us, the early challenges of this decade have resulted in greater resolve to work together to do better – for everyone.
In a strange twist of fate, the extraordinary policy responses to another crisis laid the foundation for today’s turmoil. Massive fiscal and monetary policies implemented in the aftermath of the global financial crisis rewarded holders of financial assets but did precious little for the broader economy. So, while capital markets rallied and the modest economic expansion endured for more than a decade, beneath the surface, the ESG challenges festered ─ paving the way for the divisive, populist politics that define the current era. All that was needed to fuel the flames was a spark. In early 2020, COVID-19 and its chain reactions provided that spark. Many investors are now ready to address ESG issues in their portfolios.
2. Investors Reshaping the Investment Industry
Investor appetite for indexing and transparent rules-based factor investment strategies at an affordable cost with greater tax efficiency has been insatiable in the past decade. In addition, investors are demanding more investment choices. Not surprisingly, exchange traded funds (ETFs) have been one of the primary beneficiaries of this massive industry transformation.
However, until recently, investor adoption of ESG ETFs has been, at best, uneven. Despite compound annual growth rates (CAGR) of more than 30%, ESG ETFs make up a fraction of the industry’s assets under management globally. 1 But the COVID-19 pandemic may be changing investor attitudes toward ESG ETFs. US ESG funds saw a record $14.4 billion of inflows through June 30, more than the $9.1 billion pumped into sustainable funds in all of 2019. 2
The old obstacles to ESG adoption– performance, data and analytics, cost and choice — are being rapidly overcome, enabling investors to:
Pursue sustainable performance: Intuitively, most investors would likely conclude that companies with stronger ESG practices would outperform the broader market over the long term. Strangely, many of these same investors, when surveyed about their willingness to implement ESG investing in portfolios, indicate that one of their greatest fears is giving up performance returns.
However, recent studies suggest that portfolios with ESG integration may provide downside protection when markets are struggling, underscoring ESG’s potential role as a long-term investment. Morningstar’s “ESG Indexes Protect on the Downside” concluded that 72% of Morningstar equity indexes that incorporate ESG screen lost less than the market during down periods for the five years through the end of 2019. A follow-up study after the Q1 2020 selloff found that 51 of Morningstar’s 57 ESG-screened indexes, or 89%, outperformed their broad market equivalents in the first quarter of 2020.3
Improve decision-making with better data: Over the past decade, there has been a surge in data and analytics providers all claiming to have the secret sauce to ESG investing success. This data overload has investors struggling to determine which ESG factors have a material impact on a company’s financial performance. Thankfully, investment managers have partnered with several leading-edge ESG data and analytics providers, narrowing the number of reliable choices and helping improve ESG data and analytics. The increased transparency and improved reporting help investors to understand their ESG exposures, pursue their investment goals, and monitor progress.
Gain cost-effective ESG exposure with ETFs: The average US actively managed ESG mutual fund has a total cost that is three times greater than the total cost of the average ESG indexed ETF, on an asset-weighted basis. 4 Yet, as of June 30, assets in the active ESG mutual funds category dwarf the assets in ESG ETFs and index mutual funds by more than three times.5 As investors increase their allocations to ESG, we believe they will do so through cost-effective ESG ETFs that make investment strategies once available only to the largest investors available to everyone.
Customize portfolios with ESG funds: ESG investing is deeply personal, with investors’ goals ranging from managing risk to aligning their investments with their values to pursuing sustainable investment performance. For some investors, simply excluding certain types of investments may be enough. Others may prefer a “best-in-class” investment approach that tracks an index designed to emphasize firms that are strongest in their industry with respect to certain ESG criteria or even an integrated approach that tracks an index that incorporates ESG factors while being designed to achieve a target level of tracking relative to a broad benchmark. Finally, some investors may just want to invest in an ESG theme, like increasing gender diversity in the corporate boardroom.
3. Boomers Preparing to Transfer Wealth
People complain about getting older. Yet if there are any rewards to aging, experience and perspective are probably as valuable as any. The ability to take ourselves a little less seriously is a good one, too. Comically, Baby Boomers ─ folks born between 1946–1964 ─ were shocked to find themselves in COVID-19’s “at risk” group. Boomers still view themselves as much too young to be lumped into that category for old people.
But the oldest Boomers are approaching age 75. And by the end of this decade, the youngest of them will be turning 65, retirement age. During this time of transition, according to Cerulli Associates, Boomers will pass nearly $48 trillion in assets to their heirs and charities over the next 25 years. When we include assets from Generation X ─ those born between 1965-1980 ─ Cerulli suggests that $68.4 trillion will be transferred by US households over the next quarter century. That’s the largest transfer of wealth in history.6
Something interesting has been happening during the global pandemic. Stay-at-home orders combined with the economic pain unleashed by COVID-19 have resulted in more forced family togetherness. Many younger adults have sadly lost their jobs and abandoned urban city centers to return home to the perceived safer suburbs of their youth. Not to mention college and high school students unexpectedly stuck at home with dear old mom and dad. By some estimates, more than 35% of adults between the ages of 18 and 35 are living with their parents.
Across the country, Boomer parents and their stuck-at-home children are having real conversations about personal values. This growing dialogue between parents and their children has naturally flowed into discussions about estate planning, planned giving and family philanthropy as a means to enact real societal changes.
We think of ESG investing as a bridge between Boomers ─ who are desperately trying to hold on to their youthful dreams of making the world a better place ─ and their children, who want to ensure that their actions, including their investments, are aligned with their values. State Street Global Advisors’ 2019 wealth management survey found 75% of Millennials indicate it is important that their financial advisor assist them with ESG investing.7 Ultimately, this will create a powerful joint vision for the family’s legacy that could take ESG investing into the mainstream.
From Tipping Point to Turning Point
The world has undergone tremendous changes in the past six months. For many of us, the current crises have sparked profound personal reflection and deliberate recalibration. Amid continued uncertainty, one thing is clear — we are all in this together. Buoyed by all those fighting with such passion to make the world a better place, we find ourselves at a real turning point in history, one that will radically alter – and I believe, improve – our lives.
From this year’s human tragedy, a passionate commitment to affect long-lasting, positive changes has emerged. There is no turning back. The 2010s were all about laying the foundation for ESG investing. The 2020s will be about putting ESG investing into action.