Why the ‘S’ in ESG is still in focus

September 16, 2022

“ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) issues have historically formed a solid framework for those interested in sustainable and impact investing,” says Sarah Norman, head of CIO ESG Thought Leadership in the Chief Investment Office for Merrill and Bank of America Private Bank. While the ‘E’ in ESG has recently been in the spotlight amid a deepening global energy crisis and elevated geopolitical tensions, the ‘S’ in ESG has continued to gather momentum over the last several years.

On the heels of a global pandemic that helped demonstrate the urgency for a more diverse, equitable and inclusive world, increasingly “investors are interested in issues such as economic mobility and how companies treat their workers,” notes Norman. “Social factors will likely become imperative for corporations if they are to create long-term value for shareholders and stakeholders.” What’s more, growing evidence suggests that companies with a strong focus on the health of their employees and the communities they serve may outperform¹ those that don’t, Norman adds. “We believe that the potential for above-average¹ returns lies with those companies that are having a positive impact on their communities,” she says.

In a post-crisis world, ESG considerations, with social issues chief among them, likely will remain a top priority for many companies and countries, with employee health (safety precautions, medical benefits, paid leave), along with diversity and inclusivity commitments commanding investor focus. We expect the societal trends and imperatives for corporations that have served as tailwinds in recent years to sustainable investments to further the momentum for quality ESG disclosure more broadly.

Below, Norman and Jonathan Kozy, managing director, senior macro strategy analyst in the Chief Investment Office for Merrill and Bank of America Private Bank, look at key factors propelling the growth of social investing — and what investors may consider now.

Generational change

“Millennial and Gen Z investors are especially attuned to the idea of stakeholder capitalism versus shareholder capitalism,” Norman says. While returns for shareholders remain important, stakeholder capitalism holds that businesses should be assessed on whether their actions also benefit their employees and the communities they serve as well as broader society and the environment. Rising interest in stakeholder capitalism in turn supports the idea that growing demand is expected for sustainable solutions and strategies in ESG-related investments overall.

As investors increasingly allocate capital to environmental, social and governance (ESG) funds, managers have responded by launching new funds (534 sustainable funds were available to U.S. investors in 2021, up 36% from 2020)². As a result of the accelerated adoption of ESG factors into the investment process ($69.2 billion poured into U.S. sustainable investment funds in 2021),² we expect that demand for sustainable solutions and strategies will continue to grow, which in our view may offer a competitive risk-adjusted return profile within a traditional asset allocation framework.

Shirting workforce dynamics

Labor force strength is anchored by a healthy, well-educated, racial and gender diverse workforce. Diversity of thought, an anchor of U.S. dynamism, helps drive team performance, research and development intensity and innovation. The social indicators that are useful in evaluating sovereign bond ESG risk from a macro lens include, among others, data related to innovation, health, and people (including income inequality, female labor force participation and education, for example). “Companies likely could face greater regulatory scrutiny, not just of their own social policies, but also those of the companies they do business with,” Kozy says.¹ Companies with high social standards for themselves and their suppliers potentially could perform better financially, thus benefiting those who invest in them, he adds, while those that fall behind could face financial and reputational risk.¹ Meanwhile, acute labor shortages and a historically tight jobs market have recently brought to light the importance of a company’s relationship with workers — think wages, benefits and flexibility, training and development.

All this is another way of saying that investing increasingly pivots on the ‘S.’ We believe the potential for above-average returns lies with countries and companies that are actively working to improve access to quality healthcare and services, emphasizing greater diversity and inclusion, and that are abundantly aware of their social footprint in their communities.

Access to better metrics

“Investors interested in factoring social issues into their choices can find a growing array of metrics on the progress industries and countries are making,” says Kozy. The independent, nonprofit Sustainability Accounting Standards Board, for example,identify the ESG issues most relevant to specific industries. The Social Progress Index, published by the Social Progress Imperative, ranks countries around the world based on issues such as access to clean water, the internet, basic education, health care and other factors. And the World Bank’s Sovereign ESG Data Portal, launched in 2019, provides ESG data on countries and regions.

What could this mean for investors?

We believe portfolio strategies in the coming years would allocate more capital to assets backed or underpinned by high-sustainability initiatives. Structural dynamics like rising political pressure and regulatory change are additional planks to sustainable investing and capital reallocation. Doing well and doing good have become strategic priorities of many firms and the asset managers that invest in them. Companies that are most transparent about their goals, and are better at execution, may reward investors.¹

While sustainable and impact investing aims to support a healthier society and planet, it’s vital to keep your personal financial goals at the forefront, Kozy says. “Things like corporate productivity and earnings still matter, and so do returns. That hasn’t changed.” Thus, sustainability can be an important consideration when making investment choices but not the only one. You also need to think about risk, how much time you have until retirement and other key issues, Kozy believes.

The bottom line: Output and profits matter to investors. That’s neither new nor about to change. What is new and changing is that other metrics have been gaining in importance in determining returns, flows, asset allocation decisions and the like. Now and in the future, many countries and companies may be increasingly judged on a series of ESG metrics.

As part of building a balanced portfolio, you might ask your advisor to help you identify companies or funds of companies with strong records for supporting their employees and communities, or with innovative approaches to social or environmental issues. Likewise, you may use increasingly sophisticated metrics to lessen your exposure to businesses or regions whose poor ESG performance could mean potential trouble ahead. Notes Kozy, “In the end, ESG provides investors with an additional dimension to help identify market risks and opportunities.”

For more insights, read “Sustainable Investing: A focus on the ‘S’ in ESG” from the Chief Investment Office.