Commentary: Why investors need to adapt to the changing business climate

Whether preemptively embraced by enlightened business leaders — or pushed by customers, employees, regulators and investors — companies today have no choice but to balance maximizing near-term profits with broader, longer-term social and community goals.

In PGIM's recent proprietary survey of more than 300 C-suite executives across the U.S., Germany and China, 40% said they now focus on broader stakeholder objectives beyond short-term profit maximization. This is a far cry from the Milton Friedman orthodoxy of the 1990s and 2000s, which prioritized shareholder value above all else.

Perhaps nowhere is the purposeful mindset more visible than when it relates to environmental, social and governance issues. In the U.S., shareholder proposals related to ESG have more than doubled in the past two decades, and currently account for nearly 40% of all shareholder proposals submitted to Russell 3000 companies. Thirty years ago, only about 20 companies provided any ESG disclosures to their investors. Today, that number has ballooned to 9,000 globally.

Yet, incorporating "purposefulness" into the investment process is fraught with challenges and potential missteps and requires a dynamic approach that moves well beyond the formulaic, "check-the-box" ESG rating methodologies and indexes that are still quite prevalent. Investors interested in invested purpose need an active, nuanced approach to ESG that allows them to look through the obfuscation, window dressing and data shortcomings that remain rampant.

To begin with, investors must separate companies that are truly "walking the walk" from those that are merely talking a good game — what author Anand Giridharadas recently called "the elite charade of changing the world." This requires an active approach to assessing companies that uses a combination of effort (real dollars spent), effect (measurable outcomes achieved) and controversy-based (public or regulatory reporting on ethics, compensation, diversity, consumer or other controversies) ESG metrics to help avoid window dressing by corporate marketing departments.

Even if intentions are virtuous, and not publicity driven, a company's purposeful actions may not favorably impact financial performance — but may generate broader "collateral benefits" for society. For investors with the fiduciary flexibility and desire to promote these "collateral benefits," that works just fine. However, for investors seeking to do good and do well — referring to social returns and financial returns, respectively — every well-meaning action needs to be evaluated thoroughly. A growing body of research suggests governance may be the most powerful factor driving returns in public securities and private asset classes, with environmental concerns especially important in asset classes like real estate and infrastructure that will be impacted by climate change.

Then things get more complicated. Even if an ESG factor has a material impact on financial performance, investors need to determine whether markets are already accounting for this ESG factor in the price. An asset's value may quite likely already reflect the benefits of readily available and broadly discussed ESG attributes. For active investors looking to beat the index, an ESG factor must be undervalued by the market to generate real outperformance.

The good news is such factors exist. It is important to move beyond formulaic or passive ESG methodologies and be discerning about factors that are truly material for a specific firm and industry. A one-size-fits-all approach simply does not work. One example illustrates this somewhat counterintuitive relationship.

A common ESG mantra is that company boards need to be constantly "refreshed," the conventional wisdom being that long-serving board members develop cozy relationships with executives that potentially diminish their ability to effectively advocate. However, our research shows a more complex U-shaped relationship quite removed from the conventional wisdom: longer board tenure is positively correlated with current and future book-to-value for equities, up to a point. After about nine years of average board tenure, the relationship reverses.

As investors' interest in ESG strategies rise, they must also be on the lookout to sift out asset managers that use ESG factors in name only. That is, asset managers that don't integrate relevant ESG metrics into the fabric of their investment process but still claim to run green portfolios. How far to integrate ESG considerations of course depends on an investor's goals. At one extreme, even an ESG skeptic should incorporate metrics that materially impact risk-adjusted performance. At the other, ESG champions looking to promote purposeful outcomes and companies may employ ESG metrics that provide "collateral benefits" to society — even if it means sacrificing some investment returns, if they have the fiduciary flexibility to do so.

Regardless of these complexities and pitfalls, our research demonstrates that a discerning, nuanced, active approach to ESG-sensitive investing can add real social value and improve returns. The purpose-driven firm of the early 21st century is not going away, and a powerful coalition of increasingly relevant stakeholders means it will only grow in importance over the next decade. Investors cannot afford to ignore the corporation of the future.

Taimur Hyat is chief operating officer of PGIM Inc., Newark, N.J. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.