What Comes Next for In-Plan ESG Investing?

From the headline-grabbing U.N. climate summit held in Paris to new DOL regulations on environmentally-minded investing by retirement plans, sustainability is clearly on the mind. How are providers responding? 

Real product development momentum had already been building in the environmental, social and governance (ESG) investing arena before the Department of Labor last year told investors it has no real qualms with ESG investing by retirement plans from an ERISA perspective—so long as the competitive performance of an investment isn’t compromised by tying in such factors.

Still, consensus at the time was that ESG investing had entered a new and far friendlier paradigm under the DOL’s reformed guidance, revealed by Labor Secretary Thomas Perez himself during an October 2015 press conference in New York. As long as ESG funds are attractive from a risk/return perspective they can absolutely be included on qualified retirement plan investment menus, he told reporters.

It was a striking and largely unexpected softening of the stance codified by the Bush Administration in 2008, explains Gregg Sgambati, a former RIA and current head of ESG solutions at S-Network Global Indexes, provider of ESG ratings and indexes which underlie mutual funds, ETFs and other financial products. A few months on he agrees a friendlier paradigm has emerged for ESG and retirement plans, “driven in large part by the realization that ESG is not counterproductive from a performance and risk perspective.”

In his role at S-Network Global Indexes, Sgambati says he has long been arguing that selecting low-carbon investments and meeting other sustainability or corporate governance standards has little impact on returns—and the impact it does have is likely to be positive. “To a large degree this is common sense,” he tells PLANADVISER.  

“These are well run companies that are not putting out a lot of waste and who know how to efficiently use resources to get their work done, so it makes sense they would be strong-performing companies,” he says. “Any number of academic analyses and industry-sponsored studies have confirmed as much by this point.” For example, the latest research from the Asset Owners Disclosure Project (AODP), a nonprofit group “advocating to protect retirement savings and other long-term investments from the risks posed by climate change,” suggests there is no correlation between an investor’s decision to actively overweigh low-carbon investments and the likelihood of experiencing lower returns.

In fact, AODP researchers argue that climate-based investing strategies have become “essential to protecting returns when considering the long term.” That’s because the risk attributes of climate change have a high likelihood of occurring not just in isolated regions, economies or markets—but across all geographic locations. That’s the “global” in Global Warming, says Sgambati.

NEXT: How are providers responding? 

Currently, as much as 55% of all global investments are exposed to significant climate risk, according to the AODP’s research. That’s compared with just 2% of investments that can “reasonably be classified as low-carbon.” Such is the sheer scale and potential reach of climate risk that any fund cannot claim to be looking after the long-term interests of its beneficiaries if it is not managing the components of climate risk, argues John Hewson, chair of the AODP.

Sgambati says the investment industry is slowly but surely coming to believe as much. For his firm, that means more work building indexes and models to support a variety of funds and data products in the ESG domain. One growing source of work for the firm is the construction and maintenance of custom benchmarks with the ESG flavor baked right in.

“For example we have recently been working with Reuters to construct indexes that leverage the extensive ESG data sets that they’ve already been maintaining for years,” Sgambati explains. “It’s particularly interesting work because they recently acquired a well-respected European firm that has tremendous ESG data going back as far as 1999 or 2000. They have a large and skilled research staff that has gone out and gathered great information on companies and stocks, and not just financial information.”

This is the other important point to grasp about “modern ESG investing,” he adds. “Environmental thinking is only is only one part of ESG.” Even those who are resistant to hearing about global warming can benefit from building portfolios around companies that demonstrate good governance practices, whether that be more active ownership of supply chains or a stronger commitment to the well-being of its own staff.

“These are the characteristics that set top companies apart and that will emerge in ESG rankings,” Sgambati says. “So with our work with Reuters, for example, we are able to deliver three distinct metrics across a given company's environmental impact, social standing and governance practices. We also combine them into a 0 to 100 score so it’s all very easy to grasp and use to your advantage in portfolio building.”

NEXT: Conversations with providers still ongoing 

Sgambati goes on to predict that ESG investing within retirement plans will evolve very significantly in coming years and decades.

“I like to say that this is all still playing out in the realm of the lawyers,” he says. “Product providers are analyzing the opportunities and risks, and they are talking with the DOL to get a sense for the best path forward. The next step we’ll see, I believe, is the wider integration of ESG data onto provider platforms. That’s what is still needed before a lot of this becomes actionable, especially for the registered investment adviser [RIA] community.”

From that perspective, Sgambati expects there will be “a big marketing component to all of this.”

“For RIAs in particular I think these discussions and access to the type of ESG data we are talking about could become a big value add and a way to differentiate from the competition,” he concludes. “Overall, awareness of how to use ESG and what it can do is still pretty low, but it’s increasing, in terms of the client base. And it’s not just Millennials who are interested in all this. It’s also Boomers, Gen X and those already in retirement. There’s a growing interest and it’s becoming mainstream.”