The COVID-19 crisis has not only brought on the greatest recession since World War II, but investors are also calling it the 21st century’s first “sustainability” crisis and one that has renewed the focus on climate change, acting as a wake-up call for decision makers to prioritize a more sustainable approach to investment. In this report, J.P. Morgan Research explores whether the COVID-19 pandemic could be a potential catalyst for ESG investing.
More than six months into the COVID-19 pandemic, the number of cases has topped 10 million worldwide and the global economy has been hit hard by sweeping shutdowns to contain the spread of the disease.
COVID-19 has been detected in nearly every country and preventing the virus from becoming an even deadlier pandemic has made the outbreak one of the most economically destructive events of the past 125 years, a period that includes two World Wars, the Great Depression and the Global Financial Crisis.
As a result of the radical impact COVID-19 has had on global economies in such a short space of time, many policymakers and investors are viewing the crisis as a wake-up call that accelerates the need for a different approach to investing, as parallels have been drawn between the unforeseen risks of a pandemic and issues such as climate change.
“Over the long run, COVID-19 could prove to be a major turning point for ESG investing, or strategies that consider a company’s environmental, social and governance performance alongside traditional financial metrics,” said Jean-Xavier Hecker and Hugo Dubourg, Co-Heads of ESG & Sustainability within J.P. Morgan EMEA Equity Research.
J.P. Morgan polled investors from 50 global institutions, representing a total of $12.9 trillion in assets under management (AUM) on how they expected COVID-19 would impact the future of ESG investing.
Some 71% of respondents responded that it was “rather likely,” “likely,” or “very likely” that the occurrence of a low probability / high impact risk, such as COVID-19, would increase awareness and actions globally to tackle high impact / high probability risks such as those related to climate change and biodiversity losses.
We believe that pandemics and environmental risks are viewed as similar in terms of impact, representing an important wake-up call for decision makers. The impacts of the COVID-19 crisis on the real economy and the financial system highlight the limits of most forecasting models.
“We believe that pandemics and environmental risks are viewed as similar in terms of impact, representing an important wake-up call for decision makers. The impacts of the COVID-19 crisis on the real economy and the financial system highlight the limits of most forecasting models, which do not deal well with non-linear, complex systemic risks,” said Hecker and Dubourg.
As action and awareness of long-term sustainability risks are likely to increase in the longer run in the aftermath of the COVID-19 crisis, this should be a positive catalyst for ESG. This opinion was shared by the majority (55%) of the respondents of the J.P. Morgan investor survey, who see it as a positive catalyst in the next three years. Only about a quarter (27%) of investors expect a negative impact, while 18% believe it will be neutral.
“The positive skew of expectations contrasts with the intuition that times of crisis shift the focus towards short-term economic and financial issues. Yet, it is important to note that the question specifically mentioned a time horizon of three years. Investors, therefore, are likely to differentiate between a potential negative impact in the next few weeks/months and a positive impact in the longer run,” said Hecker and Dubourg.
The recent momentum observed in ESG investing is remarkable. Once a niche, ESG investing is fast growing in every geography and assets indicated as following ESG principles may soon represent 44% of global AUM.
A growing share of investment processes, products and active ownership practices are integrating ESG principles. Using the broadest classification for the ESG market, including those following ESG principles, assets following global sustainable investment approaches could reach around $45 trillion AUM by the end of 2020.
The size of ESG-dedicated funds is considerably smaller at around $1 trillion, or around a 2% share of the market. In terms of geographies, Europe and North America accounted for more than 90% of the market in 2018.
“While ‘tipping-point’ has been used to characterize this market for almost as long as it has existed, we do believe a substantial shift is under way: stakeholders are increasingly pricing in sustainability preferences, which should lead to a reconciliation of 'sustainable' and 'financial' materiality over the long-term” , said Hecker and Dubourg.
Europe was historically the uncontested leader in sustainable finance, but its dominant position is now challenged by other region, with North America at the forefront.
Asia has long been a laggard in ESG investing, but the movement is now spreading there too and ESG disclosures regulations are being adopted or discussed in multiple jurisdictions. Japan has been among the first to adopt the trend and one of the most symbolic changes has been the Japanese Government Pension Investment Fund signing the Principles for Responsible Investment in 2015.
In terms of asset classes, equity dominates and represents around half of total ESG AUMs, but the green bond market is burgeoning and sustainability is quickly spreading to other asset classes.
Looking specifically at equity, the current trend is impressive, as inflows to ESG products have been growing steadily since 2016, offering a stark contrast with the overall outflows in the industry. The inflows in ESG products are increasing with the launch of new funds as well as the repurposing of non-ESG funds.
For the fixed-income ESG market, green bonds are by far the fastest-growing market, with expectations for $350 billon of issuance in 2020, up 36% when compared to 2019.
ESG is agnostic between active and passive investment strategies, but active management still dominates the ESG market in terms of AUM. With strong commitments towards increasing ESG integration coming from large asset managers on both the active and passive side, the future split for ESG AUM will probably follow the overall trend in asset management.
Socially Responsible and ESG ETFs have become an area of increasing focus for issuers and over the past year, this theme has continued with ETF investors even though the number of new fund launches slowed.
Assets in ESG ETFs more than doubled in the last year to around $80 billion and around another 30 ESG-themed funds were launched globally according to the 2020 J.P. Morgan Global ETF Handbook.
“Notably, iShares’ ESG MSCI USA ETF (ESGU), which launched in 2016, attracted around $6.7 billion of inflows and saw its AUM increase more than 30-fold the past year. Thanks to the fund’s large recent inflows, it has become the largest ESG ETF in the world,” said Marko Kolanovic and Bram Kaplan, Global Quantitative and Derivatives Strategists at J.P. Morgan and authors of the ETF Handbook.
In 2020, J.P. Morgan expanded its dedicated Research capabilities in both equity and index research. Two dedicated ESG specialists were hired in EMEA Equity Research to develop an integrated ESG research product while also partnering with Quantitative Research. Simultaneously, Global Index Research continues to expand its dedicated ESG research resources with an additional ESG dedicated analyst.
J.P. Morgan’s ESG indices and ESGQ stock selection framework have outperformed their respective baselines so far in 2020, as reduced exposure to commodity-heavy sectors limited some of the downside risk from the collapse of oil and other commodity prices.
Beyond J.P. Morgan products, Morningstar tracks 206 sustainable open-end funds and ETFs and reports that sustainable funds outperformed in the first quarter, with 70% ranked in the top halves of their respective categories and 44% in the top quartile, versus 11% in the bottom quartile. Virtually all ESG index funds outperformed their conventional benchmarks because they were underweight energy, the worst-performing sector so far this year.
The J.P. Morgan ESG Index Suite (JESG) now has more than $13 billion in assets benchmarked to them. In April 2018, J.P. Morgan launched the ESG Index Suite (JESG) with the introduction of the JESG suite of emerging market bond indices. The ESG Global High Yield Corporate Index (JESG GHYCI) and Asia Credit ESG Index (JESG JACI) were later launched in 2019.
Assets benchmarked to the standard and customized version of the JESG indices are expected to surpass $20 billion by the end of the year.
J.P. Morgan’s ESGQ stock selection framework and ESG dimensions outperformed during the COVID-19 induced crash, strengthening the rationale for investing in ESG strategies.
The J.P. Morgan ESGQ is a proprietary stock selection metric with eight dimensions that help investors pick stocks in a responsible way. ESGQ is constructed using three building blocks:
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