Calvert offered one of the first ESG index funds, the Calvert Social Index. The firm now has a suite of seven ESG indexes addressing issues like water, energy, corporate governance and social responsibility.
Karina Funk, co-portfolio manager of Brown Advisory’s Large-Cap Sustainable Growth strategy, overlays ESG methodology on to bottom-up fundamental stock picking. While ESG can impact a firm’s fundamentals, financial returns are driven most by a company’s financial health and growth prospects, says Funk.
“Value is created in one of three ways: Increased revenue growth, improved cost structure, or enhanced franchise value,” says Funk. “Each of these areas can be impacted or driven in part by environmental, sustainable or socially responsible strategies. There’s a fourth element that comes in, which is understanding and managing risks, and that’s another area where sustainability adds to shareholder value.”
Simplistic screens and weightings based on ESG ratings can miss the biggest opportunity for returns driven by environmental, social and governmental factors, says Funk: Firms that need to improve their ESG stance.
Companies with a desire to move from lower ESG ratings to higher ESG ratings have the opportunity to create more value than a firm with already high ESG ratings, reasons Funk, thus smart beta-like weighted ESG indexes make little sense.
“If a company can consistently find ways to reduce its usage of water and other materials, or labor, then they’re providing a value proposition to the customer,” said Funk. “When does it ever go out of style to save money? Sustainability and efficiency are huge, persistent revenue growth opportunities.”
Many successful strategies are now identifying firms with room for ESG improvement, and encouraging progress via shareholder activism, another option that is lost to most indexers.
However, investing in companies who already boast high-ESG ratings is also a form of risk management, says Eames.
“A company managing its environmental impacts is going to face fewer lawsuits in the future and will have more resources at its disposal to handle regulatory change,” says Eames. “Companies who manage their workforce as a human resource should benefit from more motivated workforces with higher moral and lower absenteeism. Companies that have strong corporate governance and ethical business practices should be more conducive to long-term growth with fewer risks.”
Calvert’s venerable large-cap Social Index has slightly outperformed the Russell 1000 over the past decade, notes Eames.