The discussion around ESG initiatives has exploded of late, with seemingly every newsletter or homepage having some mention of ESG above the fold. Much of the conversation makes mention of SFDR and the spectre of future regulation, but what about those companies that aren’t required to comply with SFDR standards? Why should those companies care about managing ESG data and delegate its integration to their data operations teams?
It should be said, first and foremost, that few companies will be exempt from complying with some aspect of SFDR, even indirectly. Any company marketing into the EU is obligated to do an SFDR disclosure, so if your company is, or is planning to, expand into the European markets, the regulation will affect you. Beyond this, however, let’s take a look at how ESG initiatives impact your business:
Return on Equity
According to a report by the CFA institute, one of the main drivers of ESG integration is risk management, specifically on the governance side. Historically, good governance criteria and metrics have proven to result in good Return on Equity (ROE), and companies that put good governance standards into practice see returns that are notably higher than their peers. A Bank of America Securities Report published in March of 2021 found that:
- S&P 500 companies with more than 33% people of color employees have enjoyed >1ppt higher ROE than their peers in the subsequent year on average;
- companies with above-average ethnic and racial diversity in the workforce see 8% higher ROE one year out compared with less diverse peers;
- Companies with above-median women in management see 30% higher ROE and 30% lower earnings risk over the next year vs. those with below-median; and
- Companies with above-median board gender diversity see 15% higher ROE and 50% lower earnings risk one year out compared with their less diverse peers
ESG Initiatives for Risk Assessment and Management
The traditional risk factors of size, value, and momentum are direct evidence that a given instrument tends to give investors a higher return. Because some, but not all, ESG characteristics fall into these categories, some people may not consider ESG itself to be a factor by the preferred nomenclature – however, big players in the ESG agency space are determining their ESG metrics as risk categorizations and assessments. Bank of America also found that with better ESG data and lower ESG risk, firms can generate alpha.
ESG data that do meet these criteria can be incorporated in signals alongside more traditional financial data to create portfolios with high returns but that are also more ESG friendly. Investors, though, will want to be able to combine various types of ESG stocks/bonds (e.g. by filtering using the hundreds of fields available now for ESG) with the time-series data that is used as the basis for developing factor investing strategies.
Wealth transfer
The CFA Institute report above also mentions that while the other driver of ESG integration globally has been client demand specifically from institutional investors, investors who want their asset managers to integrate ESG into their portfolios will have to demand it. This demand appears to be on its way. Driven by increased interest due to a $35 trillion transfer of wealth from the baby boomer generation to Gen X, millennials and other younger generations, ESG principle-based investments are poised for a boom. According to a CNBC poll, about one-third of millennials often or exclusively use investments that take ESG factors into account, compared with 19% of Gen Z, 16% of Gen X and 2% of baby boomers. In addition, 2020 was the first time ESG investments outweighed non-ESG.
While it may be a stretch to say that all people within a generation share a value set equally, it can’t be denied that the issues of climate change, inclusivity, and other ESG pillars have been consistent and growing issues for younger generations – and they’re willing to put their money on it. Firms would do well to get their ESG data under control now, before they get left behind.