Are you concerned about the environment or human rights? Do you want companies to be good corporate citizens? Then ESG investing might be a good fit for you. 86% of Millennials are interested in Sustainable Investing according to a recent poll by Morgan Stanley. It’s not just young people - 87% of women of all ages are interested in sustainable investing as well as 67% of men according to that same study. Yet, while there may be a lot of interest in sustainable investing, investor’s knowledge about the subject is low which makes it hard for people to implement sustainable investments in their portfolios.
Let’s talk ESG and returns
Traditionally, investors have worried they had to sacrifice for their values. People thought if they pursued ESG investing that meant taking on a lot of additional risk in their investments for subpar results. Frankly, if you pursued an investment strategy that was highly exclusionary or very thematic (i.e. you chose ETF’s that were all built around a “sustainable theme” such as water or wind energy) you could end up with a very concentrated portfolio that leaned heavily into one area (sometimes called a “sector”) of the stock market. This could translate into riskier portfolios.
The idea that ESG investing means lower returns does not have to be the case. Several studies have found that investing with ESG factors in mind may provide similar, or even better, results compared to traditional investments. For example, according to an October 11, 2017 Financial Times article, “a study by Oxford university and Arabesque Asset Management in 2014 also found a “remarkable correlation” between responsible investment and performance.” MSCI, which provides a number of ESG indices for investors to follow, has compiled numerous recent studies that rebut the idea that ESG investing means accepting lower returns.
If you’re interested, please follow this link to MSCI and page half way down to the section titled “Has ESG historically compromised financial returns?”
(Reminder: past performance is not indicative of future results. Also, this article is intended solely for educational purposes and does not constitute investment advice.)
ESG Investing vs. Socially Responsible Investing
If you’re asking yourself - “What the heck does ESG even mean?”, you’re not alone, ESG stands for Environmental Social and Governance. With the increase in data available it has become easier for investors to screen their portfolios for companies that also value environment, social and governance issues. ESG investing is sometimes known as SRI, or, Socially Responsible Investing. According to a report on Sustainable Investing by Morningstar, traditionally SRI investing has been focused on exclusionary screening (i.e. no tobacco, alcohol, or oil stocks, etc.). ESG investing is taking a more holistic approach to sustainable investing, perhaps combining some exclusionary screens with other measures of companies on ESG values. Some ESG managers also take a more active role as shareholders by voting their proxies in favor of ESG measures. This is an important step, proxies are a way for shareholders to tell a business how they want them to behave. Sometimes, the terms SRI and ESG are used interchangeably.
Let’s Breakdown ESG Investing
The “E” in ESG Investing
The “E” part of ESG is fairly self-explanatory. An environmental screen is either looking for companies that have environmentally-friendly practices (or don’t participate in particularly harmful practices) or is considered “best in class.” Using a “best in class” screen may result in some unusual names being held in an ESG fund or ETF.
For example, some funds that screen for environmental concerns using the best in class method include Exxon. Exxon is not exactly known for a strong environmental record. However, they are considered by some to be more environmentally friendly than other big oil companies because of the amount of money they are putting into research on low-carbon alternative energies. True story. This high research and development spending sometimes leads to Exxon's inclusion in ESG investments using a “best in class” screen.
Best in class screening
Why is a best in class screen a positive change? Think of it this way, ESG doesn’t just reward companies doing well. ESG also incentivizes companies (even in traditionally high polluting industries) to make changes by investing in best in class companies. ESG shareholders can also work from within the existing system to make changes by voting their proxies in favor of ESG issues.
(What is a proxy? Corporations typically put some matters up for vote to their shareholders. Shareholders sometimes put their own recommendations up for vote, as well. This gives shareholders more of a voice in the direction of the company- if you use your proxy vote well.)
The “S” in ESG Investing
Like Environmental, Social has an intuitive meaning. When we are talking about “Social” investing, or screens, investors are looking for companies that have positive community relations, human rights, gender and diversity practices, as well as labor policies. The Social part of ESG investing also extends to data security and privacy. Which means Equifax is pretty much out of the running for many ESG portfolios, at least for now.
The “G” in ESG Investing
The “G” part of ESG may take a little more explanation as to why it matters. Governance - OK, admittedly, this sounds boring. If you started talking about “governance” at a cocktail party people would discreetly slink away. But governance is very important, so stick with me. Evaluating companies based on governance factors means looking at questions such as: has the company been paying bribes to conduct business? Is the corporation’s board diverse? Governance also looks at executive compensation, lobbying activities, corruption, and audit committee structures.
Now that you have a better idea of what ESG investing is all about, what are your thoughts? Is ESG investing something you’re interested in? What questions do you have about ESG investing? Comment below and I’ll incorporate your questions into an future post on ESG investing.