ESG is an investment approach where investors consider environmental, social and governance factors as part of their wider research.
They might think about issues like whether the company effectively manages its carbon emissions or whether it treats its customers, staff and suppliers well.
ESG has grown in popularity in recent years due to the influence of factors like climate change and social justice on investors.
We recently caught up with Alex Edmans to get his views on the importance of ESG. Alex is a Professor of Finance at London Business School, specialising in purposeful business, sustainable investing, corporate governance, and behavioural finance.
What is ESG and why is it relevant to investing?
"ESG is the consideration of environmental, social and governance factors when analysing a company. Notice that it doesn't mean considering ESG factors alone. You will still look at normal standard financial and non-financial factors, but we're expanding the information set to also include ESG factors.
This is important because many ESG factors matter for long-term company value. A company that treats its workers well should have more productive and more motivated employees. A company that reduces its negative impact on the environment could also attract employees and customers.
If the market recognises that a company is making a positive change, this information will generally be ‘priced in’, meaning it’s already reflected in the share price and investors can’t make money from it. The special thing about ESG is the intangibility of these factors. They are often overlooked and therefore are not always priced into the market."
We believe it’s very important to consider ESG factors when making investment decisions, whatever your personal views.
Can you provide an example of ESG adding value?
“I previously carried out a study on employee satisfaction looking at the 100 best companies to work for in America and analysed how they performed over a 28-year period, 1984 to 2011.
The 28-year time period is important because ESG could outperform or underperform in one year just through luck. With 28 years, you make sure that it's not a flash in the pan. Those 28 years included downturns like the collapse of the Internet bubble at the turn of the millennium and the 2008 financial crisis. This allowed me to assess whether ESG does well in bad times, as well as good.
I found that the companies on this list beat their peers in terms of shareholder return by 2.3-3.8% per year, which is 89-184% compounded. This means employee satisfaction leads to companies doing better.
Employee satisfaction is good for firm value. If you treat your employees well, they’re motivated, more productive and more likely to stay.
However, employee satisfaction is difficult to measure, which is why it may be overlooked.
You can measure financial earnings, sales growth, you can even measure some employee statistics such as gender diversity or ethnic diversity. But can you measure how satisfied employees are, and whether they consider this company a great place to work? This is why ESG factors are being mispriced by the market, because they are harder to measure.”
What's the future of ESG?
“I believe the future of ESG is that it should become mainstream. I don't think we should have the ‘ESG’ label because a dedicated label makes it sound niche and that it's only for a certain type of investor. As I explained in the first answer, it's relevant to all investing.
If you want to invest in companies that deliver higher long-term shareholder returns, you must consider ESG factors alongside the more traditional factors.
In my view, there is no such thing as ESG investing, it's just investing. As investors should consider financial factors, they should consider non-financial non-ESG factors like management quality and brand, and then they should consider non-financial ESG factors like employee satisfaction, diversity, equity and inclusion, and a company's environmental footprint.”
Considering ESG issues can form a part of your investment analysis and decision-making process, but it shouldn’t be a replacement for fundamental financial research.
ESG in practice – 2 fund case studies
If you want to make sure ESG is considered in your portfolio, a fund could be a great solution.
We look at how two Wealth Shortlist funds consider ESG factors below.
Investing in funds isn’t right for everyone. Investors should only invest if the fund’s objectives are aligned with their own, and there’s a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.
This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. All investments can fall as well as rise in value, so you could get back less than you invest.
These funds invest in smaller companies, which are more volatile and sometimes more difficult to trade than larger companies. This makes them higher risk.
Janus Henderson UK Responsible Income
The Janus Henderson UK Responsible Income fund aims to provide a good level of income alongside capital growth over the long term, while mainly investing in the UK. Andrew Jones has been at the helm of this fund since January 2012 and has over two decades of experience managing UK equity income funds.
This fund avoids companies that do harm to society. This includes alcohol, armaments, gambling, non-medical animal testing, nuclear power, tobacco and fossil fuel power generation (although companies generating power from natural gas could be allowed if the company's strategy includes a clear plan to transition to renewable energy power generation).
Jones then integrates ESG factors by considering whether companies are doing the right thing. This includes whether the company has good governance and understanding of the carbon intensity of its products and services. The team assess whether the ESG risks for each company are meaningful and whether they impact the investment case.
The Global Equity SRI team monitors the fund and provides robust challenge on any ESG issues that crop up over time. Where ESG risks are identified, Jones and his team often engage with the company to help drive improvement. Part or all of the annual charge is taken from capital rather than income generated, increasing the potential for your investment’s capital value to be eroded.
More information on Janus Henderson UK Responsible Income, including charges
Janus Henderson UK Responsible Income Key Investor Information
Stewart Investors Indian Subcontinent Sustainability
The Stewart Investors Indian Subcontinent Sustainability fund goes beyond simply considering ESG factors. Sustainability and stewardship form a core part of the team’s investment strategy.
Fund managers Sashi Reddy and David Gait believe it’s important to understand the tailwinds and headwinds for each individual company’s business model, and that this analysis should be incorporated into their valuation estimates.
Once they understand the sustainability of each company, they like to actively engage with their senior management teams. They believe this can enhance returns and reduce risk.
They recently engaged with Indian bank HDFC to make sure that the risks posed by climate-induced flooding are being adequately considered within its lending requirements.
Ultimately, the managers believe analysing ESG information helps them understand more about the quality of companies. They think their long-term investment horizon makes sustainability even more important.
This fund’s investments in emerging markets add risk.
More information on Stewart Investors Indian Subcontinent Sustainability, including charges
Stewart Investors Indian Subcontinent Sustainability Key Investor Information
Want to learn more?
To learn more about ESG and other approaches to responsible investing, visit our responsible investment section.
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Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.