Have you ever found yourself considering a company's environmental impact when deciding on a purchase? Or have you ever decided to forgo a purchase because you doubt the company treats its employees well, or suspect it utilizes child labor? Would you boycott a company after learning about its director's financial or sexual scandals?

In case you have, you might as well want to base your investment decisions on a company's environmental and social impact. In fact, recent studies have shown that there is a positive correlation between a company's sustainability (measured in terms of environmental and social impact, as well as the governance within the company) and its long run stock performance. The focus of these types of studies was on ESG (Environmental, Social, and Governance) investing. The ESG investment strategy entails researching and factoring environmental, social, and governance variables, in addition to the standard financials. Each of the three components requires a separate focus and analysis:

·      The environmental component requires research into a variety of elements that illustrate a company's environmental impact. Environmental topics include policies, plans, and disclosures towards meeting goals in climate change, greenhouse gas emissions, net carbon footprint, issues relating to water pollution, renewable energy, recycling, environmental benefit programs, and past and present relationships with environmental regulatory bodies.

·      The social component consists of people-related elements such as company culture and issues impacting employees, customers, consumers, and suppliers, in an indirect and direct manner. Social topics include employee treatment, pay, benefits and perks, staff turnover, employee training and development, safety policies, diversity and inclusion in hiring and promotion, the company’s business mission, and the public stance on social justice issues and lobbying efforts.

·      The corporate governance component relates to the board of directors and company oversight, as well as the shareholder-friendly versus management-centric attitude. In simple terms, ESG investors analyse how corporate managements and boards relate to different stakeholders, how the business is run, and whether the corporate incentives align with the business's success. Governance topics include executive compensation, bonuses, proxy access, diversity of the board of directors, transparency in communicating with shareholders, history of lawsuits brought by shareholders, and the relationship with regulatory bodies.

The topics of all three components can be analysed in a company's sustainability report, using sustainability standards such as Global Reporting Initiative (GRI) and Principles for Responsible Investment (PRI). Websites like Glassdoor.com can be used to analyse the social component and annual proxy statements for the governance component.

Morgan Stanley Capital International (MSCI), a global provider of equity, fixed income, hedge fund stock market indexes, and multi-asset portfolio analysis tools produces ESG ratings that are highly useful when analysing companies. The ratings range from 'CCC' (worst) to 'AAA' (best). Studies from MSCI ESG Research, which are used by 46 of the top 50 asset managers and over 1,200 investors worldwide, show that high ESG ratings demonstrate higher profitability, lower tail risk and lower systematic risks in the long run, as compared to low ESG rated companies.

ESG investing is not the only sustainability investment strategy being applied in asset management. Three other existing strategies are:

1.         The traditional Social Responsible Investing (SRI) strategy, which focuses on          excluding certain industries or companies with very low ESG profiles. Examples          include tobacco, alcohol, and weapons stocks.

2.         Impact investing (elaborated on in the AMSA article series "Moving Assets Into the Future: An Introduction/Closer Look To Impact Investing"), focusing on the positive environmental and social impacts generated by the invested capital, in addition to the positive financial returns. These investors aim to see progress in their desired area by tracking indicative metrics instead of comparing their returns with the S&P 500's returns.

3.         Conscious capitalism, which emphasizes the alignment of the business with stakeholders for shared success. A company that fits within that realm does not only seek profits to benefit shareholders, but also serves other stakeholders like employees, the environment, suppliers, customers, and communities. Serving all stakeholders is thought to strengthen a business and generate long-term profitability.

ESG integration is different from the aforementioned strategies, as it includes score models of different factors. An example of an (award-winning) ESG approach in investment strategies by a large asset management fund is Robeco's score-based ESG Integration Approach. Robeco, which has its headquarters in Rotterdam, the Netherlands, has a separate office in Zurich, Switzerland, from where they investigate and interview global companies to evaluate them and assign them an ESG score, based on a comprehensive body of evidence. Evidence based means that, based on historical data, the score derived from these criteria should have an explanatory and predictive power on the investment outcome. Their strategy is to incorporate these scores into the company valuation models, resulting in a change in the valuation. Investment decisions are then based on which companies are still undervalued in the market after these newly calculated values.

Besides rating companies by their ESG footprint, investment funds are also evaluated and awarded on their ESG focus. The number of yearly global awards for investment fund's ESG performance emphasizes the increasing popularity of ESG investing. Examples of such awards include HK ESG Reporting Awards, The Asset ESG Awards, Sustainable & ESG Investing Awards and the BDO ESG Awards. Asset managers can gain great publicity and potential customers by winning these awards and gaining a reputation of being a competent ‘ESG applying’ asset manager.

The increased popularity of ESG investing, partly driven by the rewarding reputations to be gained (as with the ESG awards) may be causing a bubble; As investors with large amounts of capital are exclusively willing to invest in companies that score well on ESG evaluations, companies looking for investments are forced to focus on and improve their ESG profile. With investments going to the companies with the best ESG scores, those companies will be the ones with capital to invest and to grow, granting them a significant advantage. This bubble can thus cause those high profile ESG companies with high amounts of invested capital to grow more and thus create better investment returns, resulting in a positive feedback loop.

To conclude, sustainability investing strategies are gaining popularity in recent years, as people tend to value companies' behavior and external impacts more and more. One of these strategies is ESG investing, which entails taking evidence based factors into account, as well as standard financials, when evaluating potential stocks for your portfolio. Recent studies have shown that this strategy is positively correlated with positive stock returns in the long run. People claim that this is because customers value companies that show responsibility in an environmental, social and corporative way, whereas they boycott products of companies that do not take these responsibilities. Another theory is that the ESG investing popularity creates a bubble which causes investors to only invest in high score ESG profiles, causing them to be the only ones to expand.

The positive correlation between ESG and stock returns in the long run makes ESG investing an interesting investment strategy. People's growing interest in the environment, social norms and corporative justice promises great potential for this strategy in the future as well. 

The strategy does require substantial company and industry information. A large amount of information about the environmental and social components can be found in sustainability reports that companies publish. To compare companies' ESG components, you can use international standards like GRI and PR. The social component can also be analyzed by companies' reviews by employees, while the governance component can be analyzed with annual proxy statements.

ESG investing without this in-depth research can be done by investing in ESG ETF's, which have the ETF advantage of spreading unsystematic risks over multiple companies. When interested in ESG ETF's, www.etfdb.com (useful to find any type of ETF you are interested in) lists multiple ETF’s­­, separated by what ESG component each is focused on.