Why the ‘S’ in ESG is getting attention

March 11, 2022

ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) issues have historically formed a solid framework for those interested in sustainable and impact investing,” says Sarah Norman, director and senior investment strategist, Sustainable & Impact Investment Strategy, in the Chief Investment Office for Merrill and Bank of America Private Bank. But lately, the ‘S’ in ESG — social impact — has gotten special attention.

Amid a global pandemic and stark reminders of racial inequality, 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 that have 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-coronavirus 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 the last two 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, take a look at three key factors propelling the growth of social investing — and what investors may consider now.

An administration focused on social issues

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

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.

Investor demographics is also supportive of ESG flows, with Millennial and Gen Z investors more meaningfully aware and attuned to stakeholder capitalism versus shareholder. Per this generational cohort, a BlackRock² survey found that money managers planned to almost double their sustainable assets under management from 18% to an average of 35% by 2025. As a result of the accelerated adoption of ESG factors into the investment process seen in 2021 ($69.2 billion poured into U.S. sustainable investment funds),³ we expect growing demand for sustainable solutions and strategies, which in our view may offer a competitive risk-adjusted return profile within a traditional asset allocation framework.

The Great Reshuffle

With the U.S. workforce remaining in the spotlight, the Great Resignation — or Great Reshuffle — cannot be ignored. The department of labor reported record job openings in 2021, with 10.9 million jobs open as of December 2021.⁴ Resignations propelled by care responsibilities or early retirement are coupled with those by workers reconfiguring their careers; seeking employers aligned to their values and roles that better suit and support their work-life needs. In the search for talent amid acute labor shortages the importance of a company’s relationship with workers — think wages, benefits and flexibility, training and development — becomes ever more critical as the contract between employer and employee is being rewritten.

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, identifies the ESG standards 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 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?  

In the end, ESG factors provide investors with an additional dimension to help identify market risks and potential opportunities, and 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.