The Role of ESG In Investment

Even though it is still too early to determine whether a framework for making investments based on environmental, social, and governance (ESG) considerations is accretive to portfolio performance from purely a return perspective, there is no arguing that ESG policies are becoming an integral part of the investment management process for asset allocators. This article from Bloomberg references a survey conducted by the asset management unit of UBS (a Swiss multinational investment bank and financial service), which found that 78 percent of asset managers surveyed had implemented some form of an ESG framework to steer their asset allocation decisions. Surprisingly, while ESG considerations are becoming more popular with asset allocators, this article from the Wall Street Journal illustrates how one of the first-movers in ethical and sustainable investing is having second thoughts on their existing ESG investment framework. The board of the California Publica Employees’ Retirement System (CalPERS) is struggling with the opportunity cost that has arisen as a result of limiting their investment universe by divesting from companies that don’t meet their ESG standards (e.g. tobacco and firearm companies, etc.). Investment returns that are left on the table for any reason are hard to stomach, but the situation for CalPERS is compounded due to the underfunded position of its pension system. In order to make up the underfunded pension shortfall, increases in pension costs are putting additional pressure on the departments covered by CalPERS, and thus the underperformance due to ESG considerations is becoming less palatable.

While the jury is still out on whether large institutions divesting capital from certain companies due to ESG principles will have the desired effect (i.e. raising the cost of capital and putting pressure on companies to reform), it is interesting to observe how challenging it can be to accept negative tracking error from a benchmark over the short-term, and how it has the potential to radically overhaul investment strategy.