When Russian tanks crossed the Ukrainian border on February 24, causing oil and gas prices to spike, critics were quick to attack Western governments and investors, saying they had neglected their own fossil fuel industries in favour of renewable energy, leaving countries in a state of acute energy insecurity.

At the same time, investors who have eschewed the traditional energy sector entirely would have underperformed broad market benchmarks over the past year. As of May 19, the S&P/TSX Capped Energy Index is up 53% year-to-date, while the S&P/TSX Composite Index is down by about 5%. All of that has left many people wondering if the heyday of favouring companies with exemplary environmental, social and governance (ESG) metrics is over.

Priti Shokeen, head of ESG Research and Engagement for TD Asset Management Inc. (TDAM), says not so fast. Between January and April ESG Exchange-Traded Funds (ETFs) have taken in a record $1.6 billion in inflows, including $642 million in April. And while returns may be down this year, nearly every part of the market, other than energy, where supply has been impacted by geopolitical issues, is also in the red.

The reasons for taking an ESG approach haven’t changed, she says. Climate change is one of the most pressing challenges for companies whether they are in the energy business, consuming energy in their value chains or financing those businesses. Poor human capital management, lack of diversity, and lagging corporate governance standards are just some indicators of a business that is not well managed. In addition, the companies that take ESG seriously may have better risk profiles than ones who don’t.

“Everybody should still be concerned about ESG issues,” she notes. “At the end of the day, investors care about portfolio returns, and we believe ESG contributes to long term risk adjusted returns. Companies that manage their ESG risks and opportunities well relative to sector peers who may be exposed to the same ESG issues often have better operational and financial outcomes. We live in a world now where information flows easily. There’s a lot of attention on these topics. So, companies are very cognizant of trying to improve their ESG performance.”

Choosing the right companies

In 2020, TDAM launched a suite of three equity ETFs and in 2021 two bond ETFs to give clients and other investors an opportunity to integrate ESG into their investment objectives.  “There’s definitely a higher expectation from our clients to provide investment choices that intentionally and systematically integrate ESG factors into our passive solutions,” she says.

Since launching the equity ESG ETFs, the funds have performed mostly in line with comparable market benchmarks, in part because they do hold some traditional energy companies, but only those that are considered “best-in-class,” explains Shokeen.

One key goal, she adds, is to offer funds that can help investors reduce their portfolio risk. “We view ESG really from a risk and return dimension,” she says. “As long-term investors, we believe that ESG can contribute positively to risk-adjusted returns.”

Saying that, TDAM, which helped develop the ESG indexes, along with Morningstar, that these ETFs seek to replicate, concedes that it isn't simply about excluding certain sectors or business activities from its ETF portfolios. Rather TDAM believes that strong risk-adjusted returns and a more sustainable future can be achieved through an increased focus on ESG risks.

For instance, if a resource company undertakes a project without due attention to community support, it could risk its social license to operate, face protests and project delays or cancellations, and therefore put profits and their investors’ capital at risk. In that case, the company would presumably score lower on a comparative analysis with its peers and be excluded from the index as a result.

The company may not be a completely benign actor with respect to the environment or labour standards, but it is committed to improvement. In that way, ESG is a dynamic process that has already been seen to influence corporate behaviour for the better over time.

Commitment to ESG

TDAM has long been a believer in ESG, and it was one of the first asset managers in Canada to sign on to the United Nations Principles of Sustainable Investing in 2008. Shokeen also leads a team dedicated to ESG integration throughout TDAM’s asset portfolio; it does so by providing research and engaging with companies as shareholders. Last year it met with executives and directors of 170 firms, gathering information, urging action and voting on corporate resolutions.

“Most of our assets have a well-defined ESG integration approach within our investment processes,” she says. ESG factors where relevant inform due diligence with respect to TDAM's actively managed portfolios on equity, fixed income and alternative asset classes. But there came a time in 2020 when the organization felt the need for a suite of low-cost ETFs, with heightened ESG characteristics aimed at investors who prefer ESG focused options and prefer market like returns.

“Our objective was to offer market-like returns and create strategies that are purely ESG focused or ESG-first. The idea was to have something that looks and feels like an index fund but has higher ESG characteristics,” Shokeen says. That means investing in a diversified bucket of companies and sectors that have higher ESG performance, beyond just financial and tech companies that dominate most environmental or climate focused funds – ESG is not just about the E.”

“We take the holistic approach that every sector has a role to play in the economy,” she says, adding that its ETFs include the top 50-67%, depending on the ETF, of companies in any one sector with the best ESG metrics as rated by Sustainalytics, a Morningstar company. The goal here is again to provide investors access to similar sectors as the broad index but by investing in companies that have best-in-class ESG metrics".  The ETFs also attempt to identify companies best able to manage ESG risks over the medium to long term. With exposure to every industry, investors don’t have to time the market – their funds aren’t geared to any theme, market cycle and don't exclude entire sectors.  However, there are a couple exclusions on a company level to note. Companies that are involved in controversial weapons, small arms, gambling, or tobacco may be removed.  To learn more, TDAM has created a brochure that compares all of its ESG solutions side-by-side.

More growth ahead

ESG investing will only grow from here, says Shokeen. Millennials and other younger generations are more inclined to invest along ESG lines, while more companies are seeing the value – from a return, reputational and risk perspective – of following ESG principles.

Adoption will accelerate further once a common set of standards around what qualifies as ESG is set. That standard doesn’t exist now, but organizations such as the International Financial Reporting Standards (IFRS) Foundation and its work in establishing an International Sustainability Standards Board (ISSB), which released a new set of standards in March and is currently seeking feedback from stakeholders, is trying to get corporate disclosures on ESG on the same page. This will give investors much needed standardization in ESG information and will allow corporates to focus their reporting on what matters. The European Union also introduced Sustainable Financial Disclosure Regulation and Shokeen believes something similar in Canada would be helpful to investors. The federal government appointed Sustainable Finance Action Council is working on a Canadian taxonomy that will help define capital flows toward a transition to a fair and low carbon economy.

ESG is a long-term commitment and one that will play out over the next few decades, she says. While there will be ups and downs in any given year, being responsible is not going out of style anytime soon. “Things are evolving in this space and there is an urgency for companies and investors to pay attention to issues such as climate change,” she notes. “That’s really accelerating a focus on ESG across the industry and pushing it to evolve beyond risk management toward solutions.”