Introduction
Ethical investing refers to the investment process that utilizes moral assumptions as the primary filter for the selection of investing in securities. Scholtens and Dam (2015) define ethical investing as the moral, responsible and sustainable investment process that combines investors’ financial objectives with their interests about critical issues such as environmental, social and governance (ESG) issues. In that regard, the actualization of investment occurs under the consideration of ESG. Businesses are obliged to develop investment strategies that are not solely motivated by financial gain but also impact positively on the environment, communities, and that adhere to prevailing corporate governance policies and regulations.
Businesses then face the challenge of the continual review of ideas because the dynamics in the critical issues change with time. The evaluation of these issues allows investors to manage their funds in a manner that is consistent with their mission and values (Rubaltelli, Lotto, Ritov, & Rumiati, 2015). Due to the continual review, this research shall focus on the current state of ethical investing based on ESG issues. The recent financial crisis has led to the increased interest in socially responsible investing (SRI) in public discussions and academic literature (Von & Klein, 2015). Finally, the research shall dwell on the future direction of ethical investing.
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Key Issues in Ethical Investing
Ethical investing mainly revolves around three areas. The three factors are key drivers of the financial position of a firm which has a direct impact on the interests of stakeholders especially shareholders. Firms should strive towards operating in a way that maximizes shareholders’ wealth (Junkus & Berry, 2015). Environmental factors include climate change, natural capital, waste and pollution, natural resource conservation and animal treatment. The factors assist a firm in the evaluation of the environmental risks affecting its profitability and how to manage those risks. For instance, a firm may face environmental risks associated with its disposal of hazardous waste, management of toxic emissions or compliance with the government’s environmental regulations (Dunn, Fitzgibbons, & Pomorski, 2017).
Social factors include human capital and stakeholder opposition which significantly defines a firm’s business relationship. In this case, the firm considers whether its suppliers hold the same ideals that it contains. Secondly, the firm’s relationship with stakeholders is significantly defined by corporate social responsibility. This relationship involves the contribution of profits towards community welfare such as sponsorship of groups. Thirdly, the firm considers whether its’ working conditions indicate a high regard for employees’ health and safety (Dunn et al., 2017).
Governance factors include corporate governance and corporate behavior. Investors need assurance that accurate and transparent accounting principles and standards are used. They also want to see a fair process in voting on important issues. Shareholders need active involvement in the running of the firm, and they also expect that directors avoid conflict of interest. Finally, firms need to operate without the engaging higher powers in government to influence policy and obtain favorable treatment (Scholtens & Dam, 2015).
Generally, the underlying assumption holds that companies that are highly ranked on the ESG parameter have lower investment risk since their chances of preference by investors are high. Their return on investment is expected to be high. Fewer investors hold firms that exclude the ESG because green investors avoid their stocks. This lack of risk diversification among non-green investors results to lower stock prices for polluting firms, which increases their cost of capital. The evaluation of ESG allows investors to make a trade-off between the performance and policies of the company considering the ESG factors and its risk and return. Investors tend to avoid firms that do not have long-term sustainability initiatives. However, the expected high yields may not be achieved.
For instance, ethical screening for social responsibility enables investors to invest according to their principles. In that regard, a firm skips funds from the list of viable projects which reduces the investment area from which to choose. The skipping minimizes the depth for optimizing the trade-offs between financial risk and return. The screening, therefore, leads to an insignificant difference in returns for the socially responsible investment funds compared to conventional funds. Most academic studies argue that poorly ranked stocks on the ESG may yield relatively higher returns. The intuition in this situation is that investors avoid holding companies with poor ESG exposures which reduces the demand for shares leading to low prices currently but higher returns in the future. However, these stocks have been found to register insignificant statistical differences in returns (Bebchuk, Cohen, & Wang, 2015).
Despite the back and forth comparisons of ESG and Non-ESG firms, the amount of investments selected through sustainability screening for ESG has been growing faster than the broader universe of managed assets. This proposition is contained in Social Investment Forum’s 2010 report on Socially Responsible Investing Trends in the United States. As of 2010, the report indicates that investment assets under professional management in the U.S. clocked in at $ 3.07 trillion which was a gain of 380 percent since 1995. During the 2007 to 2010 recession, the broader universe of investment remained steady while ESG investment continued growing from $ 2.71 trillion to $ 3.07 trillion (Bebchung et al., 2015).
Current State of Ethical Investing
Ethical investing has evolved to accommodate changes in the business environment such as the ESG. Initially, businesses followed a simple triangle to represent the investment process that covered liquidity, risk and return. Currently, most firms use the magic square that covers liquidity, risk, return and sustainability as exemplified in the figure below.
Currently, the ESG ecosystem includes a diverse and complex array of private and public players and profit and non-profit players. The table below indicates a comprehensive elemental guide on ESG.
There has been an exponential growth in the number of investment funds using ESG factors from fewer than 50 in 2000 to almost 1100 in 2016. Research indicates that more than half of all funds in Australia and Europe include ESG criteria with the United States funds recording a paltry 22 percent. As of 2018 the United Nations Principles for Responsible Investment established more than a decade earlier as a public-private partnership, has more than 2000 institutional signatories committed to incorporating ESG elements into their analyses, practices and ownership policies. In 2010, Bloomberg terminals began to include ESG data and by 2016 more than 100 rating agencies were providing ESG information and company rankings. All major asset managers currently offer ESG products including J.P. Morgan, BlackRock, State Street and Goldman Sachs (Jacob, 2012).
The need for ESG investing and its growth is attributable to the continued changes in the business environment. Environmentally, there is a growing urgency to address the challenges and opportunities posed by environmental challenges such as climate change. Socially, there is a need to identify the impact that corporate conduct may have on people for instance in global supply chains. Also, the recognition that the social sustainability of business models requires alignment with societal needs. In governance, the quality of corporate governance relates closely to value creation or destruction. The current boom in ESG investing rose in the aftermath of the recent recession which intertwined failures by government and the financial industry (Rubaltelli, Lotto, Ritov, & Rumiati, 2015).
Technology is another driver of ESG investing. The analysis of ESG performance in companies has been enhanced by big data combined with more sophisticated machine learning algorithms on a scale that manual assessments cannot match. One of the leading raters indicates that it uses more than 1,000 ESG data points covering 6,400 companies globally which improves remarkable levels of transparency. Many ESG funds have begun to perform well than their mainstream counterparts. Research also indicates that firms cite investment performance in using ESG data, followed by client demand and product strategy.
Reports from consultancy and financial press indicate that demand for ESG investing will last. They contend that the factors pushing ESG investing will be boosted by a substantial intergenerational wealth transfer from generation x to millennials. In that regard, the U.S Trust indicates that 76 percent of high net-worth millennials have reassessed their assets for ESG impact versus an overall average of 34 percent. They are also twice as likely to invest in companies that incorporate ESG elements. Most millennials believe that business can be a force for social good. With 59 percent of multinational corporations playing the social role, the existing gap potentially affects millennial’s’ future investment trajectories. The percentage of women investors is also increasing. Finally, being more technologically savvy, millennials will expect personalized products and experiences which provides a clearer path for the growth of ESG investing (Rubaltelli et al., 2015)
Future Directions
The future of ethical investing revolves around the elements of ESG plus the potential for change in the details. Since it has not achieved excellent results, ESG is expected to experience significant growth to reach mainstream status. It is expected that mainstream asset managers will incorporate non-financial considerations into both stock valuation analysis and risk management (Demirtas, 2015). The stocks will be assessed from a long-term perspective and development of methods to analyze ESG elements and factor them appropriately into stock pricing models. Investors wishing to see proper management of firms will become proactive shareholders through ways such as proxy voting and engagement to influence performance. ESG is expected to continue being part of the risk reduction process.
More investors are expected to change the perception of ESG. There will be a shift from ESG as a moral philosophy instrument to ESG as an instrument for investors who are not only interested in morality but also recognize that immoral behavior hurts investment. As a result, ERG as an investment element will shift from exclusionary screening and best of class stock selection to an integrated assessment of both financial and non-financial deliberations. The investment will consider financial and non-financial issues concurrently as opposed to ESG functioning as a pre-investment decision. ESG investing will undergo exponential growth because investors will recognize that it is their fiduciary duty to look at issues especially non-financial ones such as climate change and employee welfare that can have a significant impact on shareholders’ wealth (Demirtas, 2015).
Dunn et al. (2017) argues that there is the possibility of the creation of financial analysts and ESG analysts working together to create portfolios. Globally, financial firms are expected to develop policies on sustainable investment though they may not have specialist teams. There will be sustainability funds on various niches differentiated on sustainability analytical depth. Products that are typical of ESG that demonstrate value addition will be evaluated on their merits as another investment approach. These funds will research different firms and sectors to understand the links between their sustainability efforts and future financial performance. ESG investing is expected to be exploratory and diverse, spreading into more asset classes such as hedge funds, property assets, and venture capital funds. It is also expected that ESG investing will become internationalized to cover emerging market economies.
In the future, there is a need to deepen efforts to determine ESG investments relative performance to conventional investment vehicles. There is a need to focus research on European countries that could be brought into context with the current volatility in the European financial markets (Revelli & Viviani, 2015). It would be crucial to determine the effects on ethical indices performance that could have been better than their conventional benchmarks. They may have shunned companies investing in unethical elements such as mortgage loan speculation. The indices constituents need determination as they may have changed due to the financial crisis. Currently, there is no stand-alone based empirical study comparing German ESG based mutual funds. Most empirical studies have focused on ESG based mutual fund portfolios, rather than indices (Demirtas, 2015).
It is expected that owing to the increase in index investing using exchange-traded funds, the number of published ESG indices should have increased over the years. The expansion calls for further investigation regarding the methodology behind the influence and modeling of sustainable indices. Battleground exists in steps that companies must take to become licensed for a sustainable index and how investors respond to the rising number of licensed companies included in the ESG index (Demirtas, 2015). Finally, there is anticipation in the direction and extent which ESG will go considering the increased uptake of investment by millennials and women.
Conclusion
It is evident that the ESG factors are used to establish a good business environment for various stakeholders. The interdependence between the element exhibits a correlation between stakeholders with different interests in a firm (Von & Klein, 2015). The findings indicate that the departure from the key issues significantly affects the risk and return profile of a firm considering stock prices and cost of capital. This effect owes to the increasing preference for ERG element compliant firms by investors although research has indicated select cases where it does not affect risk and return.
The current state of ethical investing has made firms adopt a broader spectrum of ESG elements. This adoption attributes to technological changes, generational change and the continued climatic changes that require firms to revise strategic ESG elements. The passage of these elements has placed firms in better positions of financial performance. Businesses still have the potential to attract more investors since they have not exhausted the adoption of ethical investing. Several changes are anticipated from the passage of ethical investing. Investor perception of ethical investing as a philosophy is expected to evolve into new ways of financing. The changed scope of operations and increased profitability will enable firms to conduct more research on investment strategies as well as research on new markets to discover investment opportunities (Demirtas, 2015).
References
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Demirtas, O. (2015). Ethical leadership influence at organizations: Evidence from the field. Journal of Business Ethics , 126 (2): 273-284.
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Rubaltelli E., Lotto L., Ritov I. & Rumiati R. (2015) Moral investing: Psychological motivations and implications. 2015;10(1):64-75
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Von W., M., & Klein, C. (2015). Ethical requirement and financial interest: a literature review on socially responsible investing. Business Research , 8 (1), 61-98. DOI: https://doi.org/10.1007/s40685-014-0015-7
