An interview with Morgan Stanley's Audrey Choi on investing sustainably
An important question in the field of sustainable investing is whether there is a performance trade-off if you start to consider ESG (environment, social, governance) factors in your investment portfolio, as if “doing good” somehow doesn’t give you the same kind of financial returns from traditional investing.
There hasn’t been much number-crunching analysis to figure out if there really is a trade-off if you want to make a positive impact with your investments. But thanks to a new report from Morgan Stanley, we now know that this perception is actually a misperception.
In fact, not only does sustainable investing not require a financial sacrifice, the opposite is usually true. According to Morgan Stanley, “sustainable investing has usually met and often exceeded the performance of comparable traditional investments, both on an absolute and risk-adjusted basis, across asset classes and over time.”
Produced by the Morgan Stanley Institute for Sustainable Investing, “Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies” (PDF) examines sustainable investing and performance and shows that while 54 percent of investors believe sustainable investing involves a financial trade-off, this is not the case.
Analyzing the performance of more than 10,000 mutual funds over the past seven years, the analysis found that sustainable equity funds met or exceeded median returns of traditional equity funds during 64 percent of the time periods examined.
In addition, the report found that sustainable equity funds met or exceeded median returns for five out of the six different equity classes examined.
I had a chance to talk to Audrey Choi, CEO of the Morgan Stanley Institute of Sustainable Investing, about the report’s findings and her thoughts about the current state of sustainable investing.
Reynard Loki: The goal of the “Sustainable Reality” report was to address the perception held by some investors that there is a trade-off in performance between sustainable investing vs. traditional investing. Can you give a little background on this?
Audrey Choi: We have seen so much interest in sustainable investing. 71 percent of individual investors (PDF) say they are interested in it, and a lot of them feel that they have an obligation to think about things other than financial returns. A lot of them also believe that companies who act sustainably in their businesses do better. And yet 54 percent still have this hesitation based on a concern that they will have to make a trade-off between profitable investments and sustainable investments.
So the point of this analysis was to see if that’s really the case. And when we looked around to see if the data already existed, we didn’t see any other studies that were broad-based analyses of a very large pool of products that were accessible products in the main markets. We looked at the data to see if there was a trade-off. And what we found was that, in fact, sustainable investments often perform better than their traditional counterparts.
Loki: Why do you think these preconceptions exist?
Choi: Part of it goes back to some of the early roots of ethical investing and old-school socially responsible investments. The pioneers of the field focused on divesting, excluding industries from their portfolios that they didn’t want to support. There were some funds and investors who saw returns that they weren’t happy with and they did have a tracking error to standard market performance. Since then, the industry has gotten much more robust and focused in the ways in which to adapt an investment portfolio to sustainable investing considerations without having that penalty.
But perceptions take a while to change, so that’s why we thought it was so important to bring this data into the mix. Also, a lot of people are used to the traditional model of making money in one place and giving it away to good causes in another. I think that for whatever anthropological or cultural reasons, many people think that when your goal or part of your goal is to “do good,” it’s probably not a financial decision. We actually believe there are some pretty significant opportunities for improving the environment and peoples’ lives that also have a very compelling growth story and profit story around them.
Loki: While it seems that some of these investors are concerned about performance, when you look at the current state of sustainable investing in the U.S. growing by 76 percent between 2012 and 2014 and the fact that sustainable investing accounts for now 30 percent of managed assets, it doesn’t seem like investors are shying away from sustainable investing.
Choi: I think you are right that there has been a tremendous and exciting growth in the field, in part because of this cycle of more investors, both individual and institutional, showing more interest. As a result, more fund managers and investment professionals are building products that allow investors to invest with both returns and mission in mind. But you still are seeing a gap between interest and action, so again, our survey showed that 71 percent of individual investors are interested in sustainable investing and on average they believe that 46 percent of portfolios should be invested this way. So, with $1 out of every $6 being invested sustainably, there is still a gap between that level of interest and the numbers.
Millennials' holisitic view
Loki: Have you found any kind of demographics split between younger investors and older investors? I would guess that since millennials are more likely than other generations to support pro-environment policies and more likely to believe that climate change is manmade, they would be more interested in investing sustainably.
Choi: Absolutely. When we did our Sustainable Signals survey, we actually did a deliberate significant oversampling of millennials and what we found was that they really are unlike the other generations. In their personal behavior and how they live their lives, they are showing some real significant differences and that’s translating into their investment behavior.
Millennials are three times more likely to seek employment with a company because of their stance on social or environmental issues. They are twice as likely as other generations to check product packaging before they buy something. They are twice as likely to buy something specifically because of its social or environmental impact.
The ways we’re seeing that translate into their investment behavior is quite compelling. They are twice as likely as someone from another generation to invest in a company or fund that targets specific social outcomes. They are twice as likely to invest in a fund that specifically uses environmental and social practices as a way to create value differentiation. They are twice as likely to divest from an investment position because of some objectionable activity in their view.
So we’re seeing a very interesting focus among millennials on a sort of integrated holistic view of the world. They want their work to have value. They want their values to be consistent with the work that they do. And they want the money that they make to be aligned with those values as well. They’re very rigorous in believing that their money should return value both financially and in terms of environmental and social outcomes.
Loki: The report found that 1) investing in sustainability often has exceeded the performance of traditional investments, 2) there is a positive relationship between investing sustainability and stock price performance and 3) sustainable investments skewed toward less volatility. What do you think are the main factors that contribute to such strength in these areas?
Choi: The analysis wasn’t trying to divine the various reasons for individual performance, but my own hypothesis around those findings is that sustainable investing is a way to make investing more robust. The additional factors that go into a sustainable managed investment as opposed to a traditionally managed investment might include extra focus on governance of the company, how employees are treated, how the community responds to the product, the employment practices of the firm, the impacts of the organization on the environment and the environmental risks to which the company may be contributing or be subject. And in my mind, all those things just help you think more robustly about risks and opportunities.
So I think that it actually makes a ton of sense that you would have lower volatility because the investments have deliberately been examined for more of these other risk factors. It is consistent with the fact that as individual firms are more mindful of resource efficiency or employee engagement and motivation, they start doing well not only in terms of being the “best companies to work for,” but also lower churn cost or lower resource waste cost, and over time it allows them to be more innovative.
The ESG standards proliferation
Loki: Currently, ESG factors are based on a company’s own self-examination to provide its figures and disclosures; at the moment in the United States there are no certifiable governmental standards in place to quantify, measure or report on ESG factors. Is this lack of third-party screening preventing some investors from getting involved or do you think that if a universal standardized rating system were put into place it would be a restriction that would hinder the growth of the market?
Choi: It’s a really interesting question. It’s actually a pretty rapidly evolving space where there are more organizations that are working on developing standards. And while certainly there are a lot of corporations reporting what they want people to know, there are increasingly a lot more organizations, nonprofits standards boards, etc. that are trying to develop more of a uniform taxonomy around that.
I think it’s important for investors to be very clear about what impact is important to them. We definitely do see the hunger from our investors that we work with that they really want more ways to be rigorous and have clarity around the impact side of things just as they’re used to understanding the score on a financial perspective.
Loki: What’s interesting is that Europe is ahead of the United States on this ESG reporting standardization because the EC has proposed amendments to European accounting legislation to require large companies to provide ESG information.
Choi: And you are seeing various exchanges around the world starting to say to companies, for example, you need to disclose climate risk. You’ve got a number of interesting things like CDP, which is having companies provide much more transparency around carbon emissions water use and water intensity. I think where you’re going to start seeing some of the really interesting drivers in broader behavior change is in companies truly looking at these factors as business drivers and not just as something that you do to comply with regulations.
Think about a large company that currently relies on an abundant supply of free or near-free clean water as an input of its manufacturing and relies on the free or near-free disposal of unclean water as an output or by-product of its manufacturing. If that company isn’t thinking about how to adjust their business model for the day in the not-too-distant future when water is not going to be free or near free, well, that’s too big of a big business risk to ignore. The company in that industry that is the most forward-thinking about how to monitor water use and impact and how to get their manufacturing process to be more efficient, they are going to be the first ones to discover interesting product innovations in a more water-sensitive world.
This kind of example could be used a million times over with almost any resource that is part of a manufacturing process that is also going to become increasingly scarce. That is where you’re going to see companies changing their behavior, not from a reporting standpoint, but from a real business standpoint. That’s where you’re going to start seeing value differentiation.
Loki: What are the biggest challenges facing the sustainable investing market moving forward?
Choi: There are quite a few challenges to sustainable investing, which is why we think it important to spend significant time on education. Through our institute’s thought leadership and capacity building initiatives, we want to address the challenges head on and help break down some potential barriers. We think the Sustainable Reality report demonstrates the inaccuracy of assuming that sustainable investing strategies provide investors with lower returns and higher risk than traditional investment products. New responsible investors need guidance navigating the full spectrum of sustainable investment opportunities, given the host of acronyms and definitions surrounding socially responsible investing or SRI, ESG, impact and sustainable terminology.
Sustainable investing has evolved significantly in the past few years — this is no longer about simply screening portfolios to remove vice stocks. Sustainable investors are now able to take a truly holistic approach activating a portfolio to generate positive societal and environmental impact across asset classes and investment styles. If we do not educate both asset owners and asset managers to take sustainable investing seriously, we will never achieve the scale necessary to truly address the social and environmental challenges that are accelerating from global population growth and rising resource scarcity.
Loki: Speaking of product choices, can you tell us a little bit about the Morgan Stanley Sustainable Investing Challenge?
Choi: The Morgan Stanley Sustainable Investing Challenge is a call to the next generation of finance professionals to match their business acumen and investment creativity with their passion for producing a positive impact. The annual competition, led by the Morgan Stanley Institute for Sustainable Investing, INSEAD and Northwestern University's Kellogg School of Management, invites graduate student teams to submit proposals that address critical social and environmental challenges, geared to attract institutional investors seeking positive impact and competitive returns.
Recently, we hosted the 2015 Sustainable Investing Challenge at the Firm’s London offices, where Blue Forest, a four-member team of students from the Haas School of Business at the University of California, Berkeley, presented their winning investment strategy. They proposed an investment vehicle that aims to alleviate drought and reduce forest fire risk, while monetizing the value of forest management to numerous stakeholders and seeking market-rate returns for investors. This year, we had 380 graduate students participate from 78 schools and 20 countries. Their ideas presented a deep interest in challenges all across the globe, with proposals targeting 27 countries and regions and issues as diverse as food & agriculture, renewable energy and healthcare.
This interview was slightly abbreviated for length.