Adviser Brian Walsh explains how the evolution of social and environmental-focused assets may now be worthy of your retirement portfolio.
By Brian Walsh Jr., CFP®
We have seen an increasing demand for environmental, social and governance (ESG) and socially responsible investing (SRI) solutions across the globe in recent years. In fact, investments in U.S. ESG funds surpassed a record $51 billion in 2020, more than double the total from the previous year and almost 10 times higher than 2018 levels, according to Morningstar.
The coronavirus pandemic and social/political events of 2020 clearly shined a spotlight on the crucial role corporations can play in driving positive change, and investors want to be part of this movement.
Let’s examine some of the key reasons ESG investing is gaining steam today and why it deserves a spot in your retirement portfolio.
Factors driving demand for ESG investing
1. Access to information and interest among emerging investors
Investors today have greater access to information than ever before thanks to the internet and advances in technology. From tracking regulatory filings online to following corporations on social media, investors are able to conduct thorough research and due diligence before deciding to invest. Gone are the days of companies operating in silos, with their leadership teams sitting at the top of ivory towers and facing little to no repercussions for their business decisions. With company policies and practices now on wide display, investors are able to act as watchdogs and hold companies accountable.
As these corporate dynamics continue to shift, investor behavior will evolve as well. There was a time when people almost solely invested in large conglomerates, banks and corporations that often had their own interests at heart. That money is now entering the largest generational transfer of wealth in history. Over the next few decades, roughly $59 trillion is expected to fall into the hands of millennials and younger investors who want their portfolios to better align with their personal values and help drive positive change. Anecdotally, more than half of our firm’s millennial clients have specifically brought up or asked about ESG investment options in recent conversations, demonstrating that there should be a clear demand for these products in the future.
As such, we are likely to see a major shift in how investor dollars are allocated moving forward, with ESG potentially poised to benefit.
2. Improvements in corporate governance
Corporate governance is a crucial facet of ESG, encompassing the structure of rules, practices and processes used to manage a company. In recent years, we’ve seen many improvements in corporate governance, specifically related to greater representation of women and people of color in executive positions.
In fact, research has indicated that a representation of at least 30% women in executive positions adds an average of 6% to a firm’s net profit margin. Additionally, companies that score well below average on sound governance policies are significantly more prone to mismanagement. That’s because companies incorporating diversity into their workforce and onto their boards invite greater diversity into their systems, processes and strategic decision making, decreasing the likelihood of any major gaps in company policies. Not to mention that when companies have strong corporate governance protocols in place, their social and environmental policies are more likely to fall in line.
Change starts at the top, and companies committed to corporate governance are likely to be the strongest drivers of social, environmental and overall economic impact as well. Adopting ESG-focused policies creates positive outcomes not only for a company’s shareholders, but also its employees and clients. Simply put, taking this approach makes a company better, and those that fail to implement appropriate ESG standards moving forward will likely get left behind.
Historically, ESG has been a relatively expensive theme to incorporate into a portfolio. Fees for ESG-focused mutual funds were much higher, causing a drag on performance. Now, investors no longer need to rely on expensive funds to get ESG exposure. Instead, they can easily invest in a low-cost exchange-traded fund (ETF) such as the iShares ESG Aware MSCI USA ETF (ESGU).
For context, from the market bottom last year on March 2 through December 31, ESGU was up 20% while the benchmark SPDR S&P 500 ETF Trust (SPY) was up only 17%. Furthermore, ESGU outperformed SPY by 6% over the last three years and 8% over the past five years.
Generally speaking, companies that were able to quickly pivot once COVID-19 hit were in a much better position for growth over the last year. Not surprisingly, many of these companies also had ESG-friendly policies in place. A great example is Tesla, which gained 743% last year despite the sell-off and subsequent market volatility. ESGU had exposure to Tesla, while SPY did not. So not only does ESG offer an opportunity to invest in companies that are doing good for the world, it provides the potential to generate meaningful returns over time.
4. Regulatory environment
The International Energy Agency reported last year that investor dollars are shifting away from fossil fuels at an accelerating rate, due to growing uncertainty surrounding fuel demand in light of the pandemic. In fact, renewable energy held up better than any other energy source last year.
Such developments are occurring against the backdrop of President Joe Biden’s proposed infrastructure bill. Called the American Jobs Plan, this bill aims to improve transportation, high-speed broadband internet and clean energy, among other initiatives. This shift toward a “green economy” will put sectors and companies that follow ESG mandates in a more favorable position.
For instance, semiconductors will be at the core of many proposed infrastructure projects. As a result, chip manufacturers like Nvidia and TSM are expected to perform well, along with others contributing to the advancement of clean energy and technology (e.g., Natera, Pacifica Biosciences). All of these companies reflect the ESG theme and investors should benefit from having exposure to them as part of a diversified portfolio moving forward.
As a result of Covid-19, we are also seeing companies such as Zoom, Square and PayPal disrupting the way we work and live, highlighting the growing shift toward digital capabilities and away from brick and mortar. Services like telehealth and virtual visits have propelled our healthcare system forward, which will continue to advance and potentially reduce the overall carbon footprint.
Taking advantage of ESG trends
With this sector so ripe for opportunity, how should retirees go about implementing ESG into their portfolios? The simplest answer is to swap a standard S&P 500 Index fund found in most traditional portfolios with a large-cap ESG fund, such as ESGU. This way, you still get broad-based exposure to high-performing and liquid companies, while excluding those that don’t meet ESG mandates.
As with any investment, there might be short-term risks that impact the immediate returns or performance of ESG funds. For example, if some of the regulations discussed above are delayed when the market is priced for them to go through, ESG investments could experience a period of short-term volatility.
Long term, however, it is important that investors of all generations position their portfolios to take advantage of the trends moving the market forward. As more corporations shift their mindset and leadership structure to align with ESG standards, companies that are not meeting these mandates risk being left behind. That is why I firmly believe ESG should be a core part of any investment strategy, even if you are in or nearing retirement. If you’re interested in exploring ESG investing, work with your financial advisor to determine if it aligns with your financial goals.
About the author: Brian Walsh Jr., CFP®
Brian Walsh Jr., CFP®, is a Senior Financial Advisor at Walsh & Nicholson Financial Group, headquartered in Wayne, Pennsylvania. Prior to joining Walsh & Nicholson, Brian served as a Senior Vice President of Investments at Lincoln Financial Group. He also holds the esteemed Certified Financial Fiduciary (CFF) designation and is a Certified Fund Specialist (CFS). Brian also holds Series 7, 6, 63, 65, Life, and Health Insurance Licenses.
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