Defining ESG Investing

Fads come and go and the world of investments is no different. Today’s “hot IPO” fades into the sunset to make way for tomorrow’s meme-stock – rinse and repeat. While some trends show staying power, others fade into obscurity, further emphasizing how fickle the world of finance can be.

While some have speculated that socially responsible investing would turn out to be one of those fads, the DOL’s recent proposal to make it easier to include ESG funds in retirement plans show that the emergence of ESG (environmental, social, governance) could very well be a foothold in the industry.

On that note, you may hear the term interchangeably used with others – impact, socially responsible, and sustainable – but for the purpose of this article we’ll simply focus on ESG.

Regardless of what you call it, it’s a fairly new field in the world of investments. Subject to obstacles (political and others) and great potential, history can provide a framework for evaluating its validity.

The aim of this article is to provide that historical perspective and dispel myths so you can make an informed decision on how ESG may/may not support your goals and values.

What are the Reasons for ESG Investing?

Several factors may play in an investors motivation to align their values with their finances. While it’s hard to say when a moral compass is headed in the right direction, below are a few of the values that can guide that decision:

Financial: Some folks may think that ethics and investing don’t mix, but will turn a blind eye in favor of what they perceive to be higher than expected profits.

Impact: In some cases returns are not all that important, so long as the investor gets to choose the good eggs and shun the bad ones.

Blended: For the most part, folks will fall somewhere in the middle. While ethical alignment is important, you still need to grow your nest egg. Both can be had.

Applying the ESG Filter

We’re all familiar with screening and sorting. We do it when we shop on Amazon and we do it before eating at a new restaurant we found on Yelp. ESG criteria works in a similar fashion:

Negative Screening: This eliminates those companies deemed to have low ESG ratings (more on the ratings later).

Active Ownership: Shareholder’s have a voice and power to wield. Active ownership aims to use this influence to direct a company’s strategies and operations. As an example, Yale notified several firms managing their funds that increased diversity hiring would be a line item recognized by the endowment.

Inclusion Strategies: On a fund level, investments are often screened for size (large, mid, or small), style (value or growth) and so forth. Inclusion strategies add ESG ratings as one of the factors for being included in the fold.

Positive Screening: Opposite of negative screening, high rated ESG companies will qualify.

What’s on the ESG Menu?

Using the above filters, there are three main ways of implementing ESG:

  • Socially Responsible Investing (SRI): In an effort to align your values and investing, SRI attempts to make tilts and allocations to sectors or companies that are at the forefront of the ESG world. These allocations involve a fair amount of forecasting, and may result in reducing expected returns.

    Example: Investing in new technologies whose effectiveness are yet to be determined.
  • Impact Investing: While SRI can be thought of as a “forward looking” strategy, impact investing focuses more on the “now.”

Example: Investing in a company that produces renewable energy regardless of the future expected returns.

  • Evidence Based Investing: Applying a historical criteria, evidence based ESG investing applies a series of time tested strategies in addition to some inclusion and active ownership filters. Some methods that may be employed are:
    • Basics of Portfolio Construction: Broad diversification, asset allocation, and cost reduction.
    • Increased Efficiency: Aversion to individual stocks or sectors based on forecasts or fads in the news.

What are the obstacles to ESG investing?

It’s hard to ignore the increase in demand for ESG. The WSJ states that more than $27 billion in ESG ETF’s for 2020, with Morningstar reporting the number of sustainable funds have more than doubled from 2017 thru 2020. While those numbers bode well, it’s important to cite that not all is as it seems.

There are three main problems to address:

  1. Is there a consistent and measurable framework for comparing ESG companies?
  2. How are the ratings utilized into an ESG driven strategy?
  3. How can companies be urged to provide valuable ESG information for said ratings?

Quality of Information

There are three main hurdles in applying ESG information:

  1. There’s not much congruity in the information that is provided. Governance is the oldest, but social and environmental are still key. The challenge is in getting more companies to willingly provide said info.
  2. Elaborating on the last point, having companies “chip in” is still difficult. The U.K. has recently made it a requirement of sorts, but they are more of the exception than the rule.
  1. Where there’s opportunity, there’s likely a business willing to earn a dollar for it. Many service providers have sprouted up to offer ESG rating services. The catch? Many use custom data, filters, and standards.

Bringing ESG Into the Fold

Now that we have a baseline understanding and know the challenges involved – should it be incorporated into your financial plan?

First and foremost, a quick disclaimer: it’s still early on in the game. Proper due diligence can take decades, if not more. How do these investments behave under different market cycles?

Do the same principles apply on an international level? Just know that only time will truly tell.

That said, early evidence suggests that a sustainable investor can achieve longer term efficient returns by applying some of the same tenets of traditional investing:

  • Believing in the long term efficacy of the markets.
  • Understanding why you’re invested (your ultimate goal).
  • Keeping a wide diversity to your investment plan.

While challenges remain, they are not specific to the ESG world. Traditional investing has its issues too. That said, if you’d like to align your money with your values, remember to look under the hood and be assured of what you are actually purchasing.

Does it fit what you want in terms of values or future value – perhaps both?

Know that it’s not all or nothing – you can just as easily use a traditional approach and incorporate ESG as a tilt to the balance of the portfolio.