Nowadays, younger generations are mainly concerned about issues like the protection of the environment, the elimination of discriminatory practices and the reduction of the social inequality gap. From this perspective and following the increase in the number of savers who choose to endorse these decisions by investing in socially responsible funds, some companies have had to adapt their management to this philosophy in order to raise capital.
This led to the development of the Environmental, Social and Governance (ESG) principles. The ESG principles are a series of standards that guide socially responsible investors in their decision-making process, since they allow investors to evaluate the impact that companies have from an environmental, social, and corporate governance point of view.
This principle is mainly related to subjects such as climate change and sustainability of natural resources. It takes into account, for example, how companies treat animals, how efficient is their energy management and waste disposal, how accurate they are in the assessment of environmental risks and which measures are taken to control them.
On this subject, the focus is placed on the evaluation of the relationships that companies establish at different levels, analyzing whether they make a positive impact on the community, what are the working conditions of their employees, if their suppliers share these values, among others aspects. In this way, investors can visualize the spectrum of the actions of these companies in their environment, and their link with society as a whole.
Principles related to Corporate Governance are largely focused on the practices that take place within the company. The management of conflicts of interests, accounting transparency and the decision-making process are closely evaluated; and discrimination of any type against employees is thoroughly monitored. Lately, two topics have become very relevant: the disclosure of the top executives’ bonus percentages and the distribution of the highest corporate positions in terms of gender.
But these principles have a much wider approach, and multilateral organizations such as the World Bank (WB) and the United Nations (UN) have been paying attention to the subject. The WB has encouraged the development of socially responsible investments by offering products that fit within the ESG criteria. In 2005, the UN established the Principles of Responsible Investment (PRI), which involved 20 institutional investors from 12 countries, requiring their commitment to the implementation of environmental, social and corporate governance issues within their investment process.
In terms of investment strategy, these principles work as an additional aspect in traditional financial analysis, and as a tool to determine which business areas or types of companies are best suited to the specific profile and values that investors wish to see reflected in their portfolio. Thus, in active management, investors look for companies that follow these principles, while in passive management the most common options are ETFs (Exchange Traded Funds) that follow ESG indexes and Mutual Funds, where the focus is set on investing in companies that abide by this perspective. ETFs or Exchange Traded Funds are funds specifically structured to follow an index, such as the Ishares MSCI KLD 400 Social ETF.
Chart N° 1. Report elaborated by Gandini Análisis. Data by Bloomberg.
The MSCI KLD 400 Social Index, created by MSCI Inc., is one of the most representative indexes related to the ESG principles. This Index, which has been carried out under different names since 1990, consists of 400 U.S. companies that comply with these standards. Chart N° 1 displays its series since July 2008, which allows the evaluation of the behavior of the index in a timeline that goes from the last financial crisis to the situation derived from the Covid-19 pandemic. It is clear that the index reflects a growing trend, which represents an increase in the value of the shares of the companies included in its basket. This trend, that started in late 2017 and early 2018, has continued, but it has also become more volatile amid the rising trade tensions between China and the United States.
This year, the chart shows an evident decrease during February and March representing a 33 percent reduction in its value, due to the uncertainty caused by the increase in Covid-19 cases and the impact it has had on many economic sectors. However, it must be noticed that as of August 5 the Index was located at 1,255 units, getting close to a full recovery. Even when the increased appetite in the US stock market has been a constant force since April 2020, and KLD 400 stocks have benefited from this dynamic, the historical trend shows a structural rise in this particular type of assets.
Another type of investment asset that is currently in use in several countries are green bonds. The special feature of these bonds is that the funds obtained must be used to finance projects related to the conservation of the environment. This type of titles may attract investors because they are given a differential tax treatment, but in order to be classified as “green” they must be verified by a special entity.
Chart N° 2. Report elaborated by Gandini Análisis. Data by Bloomberg.
Even though the first green bond was issued by the World Bank in 2009, these assets began to gain strength and relevance in the international market as of 2016. Chart N° 2 displays the behavior of the Bloomberg Barclays MSCI Global Green Bond Index, representing how this market worked during last year. The decrease is similar to that shown in Chart N° 1, and is also related to the uncertainty caused by Covid-19. On the other hand, the Chart reflects the recovery of the Index, derived from the renewal of the investors’ interest in this type of asset.
The growing strength of the ESG principles is quite clear. In this Pandemic context, and in a post-pandemic future, investors are readjusting not only their expectations but also the way they see the world. They will keep these standards in mind, as they continue to become increasingly relevant. Therefore, understanding the ESG principles’ scope and evolution is of vital importance in a rapidly changing world where there are many people who wish to act in a more responsible way.
Report elaborated by Gandini Análisis for SupraBrokers only as content. It shall in no case be considered as an investment recommendation.