ESG ecosystem: A study on investment prospects, market expansion, and unrealised potential

With changing investor preferences, new opportunities are opening up for investment managers.

• The discussion is moving away from whether ESG investing is a niche to how investment managers should respond as authorities across the world continue to take client feedback and work to enact ESG investing criteria in their respective countries.
• By 2024, half of all professionally managed assets will be ESG-mandated assets, which are defined as professionally managed assets in which ESG issues are taken into account when choosing investments or shareholder resolutions on ESG issues are filed at publicly traded companies.
• Over the following 18 months, the bulk of new ESG fund launches are anticipated to follow guidelines akin to Article 8, or, put another way, with ESG features playing a significant part in the investment.
• Investment managers can allay regulators' and investors' worries by performing a comprehensive evaluation of disclosures relevant to ESG investing and enforcing associated compliance procedures uniformly across the organisation.
• A road ahead for adopting sustainability efforts and enhancing customer involvement may be provided through responsible digital transformation. When analysing the performance of financial institutions, more and more stakeholders are taking societal repercussions into account in addition to financial measurements. Investment management businesses may profit from verification or assurance by an impartial third party in order to give the information required to execute this kind of evaluation.

ESG metrics consideration in investment is becoming commonplace

Some experts think we've reached a turning point when the expansion of professionally managed assets with an ESG mandate will continue to pick up steam until it accounts for the great majority of all professionally managed assets. Others, however, are less convinced that such a significant change has occurred and point out that investment philosophies that are linked with ESG or comparable issues have been developing for decades and are therefore unlikely to ever transcend a certain niche.1 However, data from fund prospectuses implies that ESG has gone into the mainstream. While some still dispute whether ESG has formally transitioned from the periphery of investing philosophies to mainstream acceptability by international investors. Prospectuses for investment funds without sustainability declarations are getting difficult to find.

Even funds classified as "non-ESG," or Article 6 funds, in the European Union (EU), which lack ESG objectives or features, are required to report how sustainability risks are taken into account when making investment decisions.2 The discussion is moving away from whether ESG investing is a niche to how investment managers should respond as authorities across the world continue to take client feedback and work to enact ESG investing criteria in their respective countries.

The debate is shifting from whether ESG investing is a niche to how investment managers should respond.

Investment management companies have a chance to upgrade their internal stewardship processes, improve customer reporting capabilities, and retool their investment decision engines in order to meet and possibly exceed client expectations as a result of the continued rise in sustainability-mandated investment demand from investors around the world. Companies are less likely to take a "wait-and-see" or "do-nothing" strategy for strategic reasons as they become more aware of the consequences of inactivity in relation to ESG investment. Investment managers may pick which ESG themes to take into account in their product offerings by looking at how ESG product growth has changed over the past several years for insights into the strategies that are satisfying client demand. Companies that take too long to act allow customers to invest their funds in a product that they believe to be more suited and reliable.

Some businesses are building their reputation by putting sustainability at the centre of their decision-making in order to meet the rising expectations of regulators, investors, and workers in order to take advantage of the increased investor allocations to ESG-aligned investments. Investment managers may gain more credibility in the eyes of stakeholders by engaging with workers about the company's mission, enhancing openness about the company's ESG investing practises, and simplifying disclosures regarding the firm's effect on ESG-related objectives.

The global professionally managed ESG assets landscape continues to expand

The demand for ESG goods among investors throughout the world keeps opening doors for organic AUM development. Recent studies show that investment managers' consideration of sustainability investment criteria in their decision-making processes is still driven by client demand.3 The entirety of the professionally managed ESG market is the topic of this paper. Read the Casey Quirk by Deloitte study for an analysis of dedicated sustainable investments, a subset of this ESG universe: Being green is difficult: Managing real change in the context of sustainable investing. ESG-mandated assets, which are defined as professionally managed assets in which ESG issues are taken into account when choosing investments or shareholder resolutions on ESG issues are filed at publicly traded companies, are on track to account for half of all professionally managed assets globally by 2024 at their current growth rate.

The global growth in ESG-mandated assets is expected to be significantly influenced by the adoption of new disclosure regulations in the EU, particularly the Sustainable Finance Disclosure Regulation (SFDR) introduced in March 2021. SFDR categorizes funds into Article 6, Article 8, and Article 9 based on the extent of ESG integration in their investment decision-making processes. By the end of Q1 2021, assets in ESG-focused mandates, Article 8, and Article 9 funds in the EU had reached $13 trillion, accounting for 40% of total assets under management. This regulatory progress highlights the EU's leadership in shaping ESG investing globally and is likely to raise investor awareness and adoption. In 2022, further clarity is expected regarding fund designations under SFDR, and more funds are likely to embrace Article 8 and Article 9 categorisations as disclosure requirements become clearer.

Investment management firms worldwide are adapting to the surging investor demand for ESG-aligned products by rebranding existing funds and introducing new ones tailored to specific sustainability goals. In 2021, the number of exchange-traded funds (ETFs) and mutual funds designed with ESG characteristics or objectives mirroring Article 8 or Article 9 principles witnessed a remarkable growth of over 35% compared to the previous year, totaling more than 1,600 new launches across 48 jurisdictions (excluding the United States). This constituted approximately 12% of all fund launches. Within the United States, 149 mutual funds and ETFs with ESG attributes were introduced in 2021, accounting for around 22% of all fund launches. These figures indicate a substantial increase in ESG fund launches, with stronger fund flows supporting the case for investment managers to consider ESG-aligned offerings. Actively managed ESG funds attracted inflows, while their non-ESG counterparts experienced outflows. In 2022, actively managed mutual funds and ETFs with ESG objectives are expected to capture a growing share of active fund launches globally

Sustainable investment products that are meeting client demand

The landscape of ESG investment products is undergoing a significant transformation as investment managers respond to the evolving demands of clients and investors. This shift is marked by a departure from traditional negative screening approaches and a move towards products that not only integrate sustainability factors but also quantify their impact on specific E, S, and G (Environmental, Social, and Governance) factors. This nuanced approach aligns with the growing preference among clients for investment products that offer a finer focus on E, S, and G considerations.

The analysis reveals a substantial increase in the number of institutional investment managers reporting at least one ESG-aligned fund in their holdings, growing by almost 300% since 2016. These ESG-aligned funds are now found in 24% of all 13F filings for the period ending Q3 2021. Among all ESG funds held in portfolios, those with a general ESG mandate have grown from representing 38% of all ESG-aligned funds in 13F filings in 2016 to 53% by Q3 2021. Notably, while the number of 13F filings with water-focused ESG funds has increased, their percentage among all ESG funds has declined, indicating slower growth for specialty water-focused funds.

Within the 207 different ESG-aligned funds identified across 13F holdings at the end of Q3 2021, 66% can be categorised as general ESG funds, suggesting that both US retail and institutional investors have a sufficient supply of general ESG funds to choose from. While general ESG funds appear well-represented, there is potential for new fund launches in specific ESG categories, particularly in renewables. These funds currently represent 30% of all sustainability holdings in 13F filings but account for only about 8% of the 207 ESG-aligned funds analysed in Q3 2021. The analysis also reveals that alternative investment managers are increasingly offering ESG-aligned strategies, with exempt offerings featuring ESG themes growing 50% in 2021, outpacing the 33% growth in total Form D filings. A significant shift occurred in 2021, with climate-focused private funds gaining substantial traction, representing 27% of all ESG-aligned themes, up from just 1% in 2020. This trend reflects the increasing investor focus on climate-related issues and the transition to clean energy.

The ESG investment product landscape is witnessing a significant transformation driven by evolving client and investor demands. This shift is characterized by a departure from traditional negative screening approaches towards products that not only integrate sustainability factors but also measure their impact on specific Environmental, Social, and Governance (ESG) aspects. This nuanced approach aligns with the increasing preference for investment products that offer a more refined focus on ESG considerations. As ESG fund objectives expand, different sustainability goals are attracting varying levels of fund flows. In the United States, an analysis of SEC filings reveals a substantial increase in institutional investment managers reporting ESG-aligned funds in their portfolios, growing nearly 300% since 2016. While general ESG funds dominate, there is potential for growth in specific categories like renewables. Alternative investment managers are also offering more ESG-aligned strategies, with a surge in climate-focused private funds, reflecting investor interest in climate-related issues. Overall, the evolving ESG landscape underscores the dynamic nature of sustainable investing, with greater emphasis on impact measurement and targeted ESG strategies expected to persist.

Adopting a sustainability ethos as a differentiator

Investment management firms like Candriam and T. Rowe Price are recognizing the importance of incorporating an ESG (Environmental, Social, and Governance) lens into their investment processes. ESG research is becoming integral to their investment decision-making, reflecting a broader industry shift towards ESG integration as a standard practice rather than a unique selling point. Global regulators, inspired by the EU's actions, may require fund categorization based on ESG incorporation levels, simplifying investor choices. In this increasingly crowded ESG landscape, firms are finding that differentiation goes beyond product offerings; it's about instilling a sustainability ethos within the organization. Authenticity in ESG efforts reinforces a firm's vision, fosters collaboration, enhances talent retention, and aligns with employees' values. Disclosing specific ESG goals and tying executive compensation to them underscores leadership commitment. As the industry faces high turnover and a shortage of ESG-savvy professionals, firms can boost credibility and reduce voluntary turnover by transparently communicating progress toward sustainability objectives.

ESG incorporation may no longer be a differentiator for investors, but rather a standard input for consideration in the investment decision-making process.

Transparency to increase authenticity

Shareholder proposals related to environmental and social issues are increasing globally. However, some ESG (Environmental, Social, and Governance) funds have voted against such proposals, raising questions about their commitment to ESG principles. For instance, some funds have opposed resolutions advocating for board diversity and disclosure of sexual harassment policies, despite claiming to prioritize these issues. While fund managers may have valid reasons for their votes, the lack of transparency in their rationale has led investors to question their dedication to these causes. To address this, investment management firms have an opportunity to review their proxy voting processes, ensuring that their votes align with their stated sustainability objectives. Recent actions by regulatory bodies like the SEC highlight the need for clearer and more precise ESG disclosures in marketing materials and client education efforts. Implementing compliance policies consistently can help alleviate concerns from regulators and investors and demonstrate a genuine commitment to ESG principles.

Disclosures for differentiation

In the evolving landscape of ESG investing, investment management firms are recognising the importance of demonstrating an authentic commitment to sustainability. This extends beyond proxy voting and employee engagement to encompass process improvements throughout the organisation. Investors are increasingly seeking detailed insights into how firms holistically incorporate ESG practices. Due diligence questionnaires now delve deeper into ESG criteria, prompting investment managers to explore comprehensive integration strategies. However, quantifying the impact of initiatives like diversity and inclusion remains a challenge for many firms. Reporting progress to investors is also becoming complex as firms set detailed sustainability goals. Frameworks like UNPRI provide a structured approach to monitor responsible investment activities and enhance transparency. While regulatory requirements in the U.S. may be less defined than in the EU, clients are increasingly demanding transparency regarding sustainability risks and factors. Responsible digital transformation can facilitate the adoption of sustainability initiatives and improve client engagement. With stakeholders considering societal impacts alongside financial metrics, independent third-party verification or assurance may become valuable for investment management firms striving to provide the necessary data for such assessments.

Sustainability and the drive toward a more human-centric investment management industry

As ESG investing continues to grow, investment managers have a unique opportunity to contribute to a more sustainable world where social and environmental concerns are as important as financial profit, benefiting all stakeholders. To capture a larger share of ESG assets under management (AUM), investment managers can prioritize building products with sustainability at their core. Clearly defined strategies regarding sustainability risks and outcomes can enhance regulatory compliance and provide valuable information to clients. The adoption of ESG performance assurance, proxy activism, and increased disclosure requirements may further boost ESG-mandated AUM in the coming year. In 2022, sustainability investing is expected to gain more traction among both retail and institutional investors. Firms that engage with talent, increase transparency, and report progress on sustainability goals will be better positioned to meet the evolving expectations of today's clients.

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