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Portfolio > Portfolio Construction > ESG

SI Surges as Advisors Remain Skeptical

By Bernice Napach

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2019 was a boffo year for sustainable investing. Not only did fund flows explode, setting new records, but performance excelled.

According to a recent report from Morningstar, sustainable asset fund flows reached a record $21.4 billion in 2019, four times the amount in the previous year. The number of sustainable mutual funds and ETFs increased by more than 30.

As of the end of 2019, there were 303 sustainable funds, compared with 270 last year, and 564 funds that consider environmental, social and governance factors in their investment strategy, up from 81 funds in 2018.

Many of these funds also outperformed their traditional fund counterparts. Thirty-five percent of sustainable funds finished 2019 in the top quartile for performance and two-thirds ended in the top half, according to Morningstar.

Sustainable equity funds did even better, with 41% ranking in the top quartile of their respective categories and 68% placing in the top half. Fixed income sustainable funds, in contrast, clustered in the middle two quartiles, performing in line with the averages of traditional funds in the same categories.

Beyond these data points are the recent announcements by BlackRock that sustainability is its “new standard for investing” and by State Street championing the importance of sustainability in investment strategies. On Tuesday, JPMorgan announced that it will no longer finance oil and gas drilling in the Arctic or mining for coal, as Goldman Sachs had announced previously, and will allocate $200 billion by 2025 to finance sustainable projects.

Morningstar expects asset managers will continue to introduce new sustainable funds, which come in three types: ESG focus; impact/thematic funds, which use diversified strategies in lieu of conventional ones across most asset allocations; and sustainable sector funds, which invest more narrowly in industries and companies that produce sustainable products and services needed for a transition to a low-carbon economy.

In addition there are funds that consider ESG criteria in their investment analysis, though the criteria may not play a role in the selection of specific assets and funds that were repurposed from traditional to ESG focus or impact/thematic.

Jon Hale, Morningstar’s director of sustainability investing research who wrote the report, is optimistic about the growth of sustainable investing. He expects asset managers to launch more sustainable funds and increase the use of “ESG consideration” in the investment process of all their funds.

Regulators will require more ESG disclosures from companies and view ESG analysis as “an important component of fiduciary duty,” Hale expects. Also, “intermediaries [will] more fully embrace sustainable investing” and evaluate the tools funds use to apply ESG factors and achieve impact beyond financial return, he says.

That said, most financial advisors currently “are not proactively incorporating ESG into their investment process,” according to a new report from Practical Perspectives based on a survey of 685 advisors in January 2020, 85% of which were RIAs or IBDs.

Fewer than one in 10 advisors “incorporate ESG as an explicit element of their value proposition to clients and believe strongly in the concept or investment case for ESG investing,” although 35% do use some ESG strategies for clients, usually at the client’s request, according to the report.

It found that the main impediments to using ESG investments were lack of standards defining ESG or the absence of methodologies to assess solutions, lack of interest from clients and lack of training and education about ESG.

Don’t Need To Avoid Traditional Index Funds

You don’t have to invest clients’ money in funds focused on ESG concerns to address their preference for socially responsible assets. A traditional index fund may suffice if the fund management company has a record of voting in favor of ESG-related shareholder proposals, and more asset managers are doing just that, according to a new Morningstar report.

Morningstar studied how the 50 largest fund companies voted on 1,033 ESG-related shareholder resolutions over the past five years — excluding the votes of their ESG-themed funds — and found that support for such resolutions has grown to 46% from 27%.

DWS, Allianz Global Investors, Blackstone, Nuveen and AQR were the five most ESG-supportive fund companies over the five years from July 1, 2015 through June 30, 2019; Federated, Hartford Funds subadvised by Wellington Management, J.P. Morgan Asset Management, Pioneer Funds and American Funds were the least supportive.

During the 2019 proxy season, Allianz Global, Blackstone and DWS placed in the top five fund families in support of ESG-focused proxy votes along with Eaton Vance and Pimco; American Funds, Dimensional Fund Advisors, Vanguard, BlackRock’s iShares and T. Rowe Price were among the five least supportive of such resolutions.

Looking Ahead

Early this year, BlackRock, the world’s largest asset manager, committed to placing “sustainability at the center of [its] investment approach and disclosing its proxy votes on a quarterly rather than annual basis,” and its CEO Larry Fink announced that the firm will be “increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”

State Street Global Advisors CEO Cyrus Taraporevala said his firm “will take appropriate voting action against board members” of companies included in the leading global stock market indexes that lag in addressing financially material ESG issues, based on State Street’s proprietary measurement.

“Everyone will be watching their voting records; it will be interesting to see how those records change,” says Jackie Cook, director of manager research and co-author of the Morningstar report.

There’s plenty of room for improvement. According to Morningstar, BlackRock voted in favor of ESG-related shareholder proxies just 7% of the time, the same as Vanguard. State Street’s approval rate was 27%. Of the remaining fund families in the top 10 by assets, only DFA, at 1%; T. Rowe Price and American Funds, at 11% each; and Fidelity’s active funds, at 17%, scored lower than State Street.

Vanguard, the second largest asset manager, has been “very loud in its silence” on ESG-related proxy issues, says Cook.

Other asset managers substantially increased their support of ESG shareholder proposals in 2019, including American Century, Lazard, MFS and Geode Capital Management, which manages Fidelity’s index funds, according to Morningstar.

Passive vs. Active

The Morningstar report poses a challenge to the conventional view that passive asset managers are less equipped to manage assets that focus on sustainable assets outside their ESG-focused funds because they can’t influence corporate behavior by selling shares. They have to own the index.

That condition, however, puts “more responsibility on those funds to actively vote” on ESG-related shareholder proposals, says Cook. “Their risk is systemic risk, which can impact the market as a whole. They have a real interest in watching out for climate risk, for accountability and more, and they are in a powerful position to address those risks in proxy voting … to consider the material risks that affect the financial system related to ESG factors.“

SEC Proxy Proposals

The growing interest in ESG-related shareholder proxies among asset managers comes at a time when the Securities and Exchange Commission has proposed new rules that essentially will restrict the number of shareholder-supported proxy votes, including those related to ESG issues.

One proposal raises the stock ownership threshold to sponsor a first-time proxy proposal, while another would require proxy advisor firms, which advise asset managers on votes, to include a company’s response to a proposal in the recommendations they distribute to clients.

“These rules would stop some proxy issues in their tracks,” says Cook. “Some start at the margin and become more central,” based on news and developments. “Without shareholder resolutions allowed to enter at the [lower level], you don’t end up with the same level of debate later on and the market could be taken by surprise” when material investment issues develop that could affect stock prices, such as the opioid crisis on drug stocks and mass shootings on gun manufacturers. “The groundwork has been laid,” Cook adds.

Morningstar opposes the SEC proposal that would limit proxy resubmissions, noting in its comment to the agency that the proposed rule “would stifle investors’ voices” when it comes to corporate governance.

Bernice Napach is ThinkAdvisor.com’s senior writer and can be reached at [email protected].

Bernice Napach

@Think_Napach

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