By Chéo Scott, CFA®, CIPM®
Have you considered integrating Environmental, Social, and Governance (“ESG”) factors in your investment portfolio? If so, you’re not alone. Investors are taking notice. The common premise an investor gives up returns when choosing ESG investments has not really held. Depending on the methodology applied, ESG can enhance the risk and return asset selection framework. Over recent years, evidence suggests a noticeable uptick in interest for ESG investments. Prospectuses of more than 100 "conventional funds" added ESG criteria since the start of 2019. The language change allows portfolio managers to integrate ESG in the future – a clear attempt to meet an expected growing demand.
Standardizing ESG factors in investment analysis remains a work in progress. Equity and Fixed income analysts may capture some ESG issues. However, no universal framework exists for how ESG should be integrated among institutional or retail investors. The existing terminology may be used ambiguously and cause confusion. Here are a few terms to research: “PRI”, “SRI”, “ESG”, “Socially Conscious Investing”, “Green Investing”, “Ethical Investing”, “Impact Investing”, “Greenwashing” “Sustainable Investing”, “Responsible Investing”, and “Thematic Investing.” These terms are frequently mentioned in the investor community.
I've included descriptions below and encourage you to do some additional research to find what's true versus what's just noise.
PRI (“Principles for Responsible Investment”) – Acts as an independent network encouraging investors to use responsible investment to enhance investment returns and better manage risk. The organization ("PRI") engages with global policymakers and is supported by, but not part of, the United Nations.
ESG (“Environmental, Social, Governance”) – Represents a set of standards socially conscious investors use to screen investments.
- Environmental criteria may include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also be used in evaluating any environmental risks a company might face and how the company manages those risks.
- Social criteria look at a firm’s business relationships - with employees, suppliers, clients, and communities. Investors care that company values align across business relationships. Do production quality and safety standards meet expectations? Are their equal employment opportunities? Does the firm create a positive local community impact such as through volunteer opportunities? Are there health care, education, and housing services? Do working conditions reflect a company that values its employees?
- Governance criteria consider standards for company leadership, risk controls, and shareholder rights. Investors will look at accounting method accuracy and transparency, board independence and diversity, voting rights, ethics, conflicts of interest, and executive pay.
Integrating ESG criteria in the investment process can serve an important role in reducing risk by helping investors avoid investing in companies that accrue major losses. Environmental, social, or governance catastrophes like the 2010 BP oil spill or the 2017 Pacific Gas & Electric California wildfires are examples of major events impacting company profitability.
SRI (“Socially Responsible Investing”) – Typically, SRI is associated with “negative screens.” This means an investor seeks to avoid harm by not investing in companies perceived to have negative social effects. These companies may include weapon manufacturers, tobacco companies, and fossil fuel producers. Investors may consider “negative screening” as a reactive approach compared to “Impact Investing.”
Impact Investing – Investments made in companies, organizations, or investment funds directed to generate a measurable societal or environmental benefit. Investors consider impact investing a proactive approach to addressing environmental and social issues.
Environmental and social criteria for investments vary and can be subjective. They tend to be wide-ranging as well. This is why it's critical for ESG investment advice between financial advisors and investors to be clear and transparent. Investor perception of ESG may differ based on the products sold by financial advisors. As an example, SRI products relying only on negative screens can be marketed as ESG products. Let's say the client looks for more besides their assets passing negative screens. The client may later find their portfolio holdings do not philosophically align with their objectives. The product sold to them differs from their belief system. This is why client investment objectives should be clearly outlined and documented. They should be aware of the nature of the investments and if it meets their ESG impact standards.
Incorporating ESG criteria in the investment portfolio can be extremely valuable to a long-term investor. We encourage those committed to aligning their investment assets with their impact priorities to do the following:
- Explicitly state your environmental, social, and/or governance objectives.
- Determine what percentage of your overall portfolio should be fully aligned with your concerns and goals.
- When working with an advisory firm, ask questions to assess the depth of the firm’s ESG and SRI knowledge and resources.
- Be diligent in understanding your ESG and/or SRI investments from all angles.
- Monitor and revisit the above steps regularly.
If you would like to find out more information about ESG investing, feel free to email me at firstname.lastname@example.org. To learn more about GRID 202 Partners you can visit https://grid202partners.com/.
Important Disclosures: The information provided herein does not constitute a solicitation or offer by GRID 202 Partners or its affiliates, to buy or sell any securities or other financial instrument, or to provide investment advice or service. Nothing contained herein should be construed as investment advice or a recommendation to purchase or sell a particular security. Investing involves a high degree of risk, and all investors should carefully consider their investment objective and the suitability of any investments. Past performance is not indicative of future results. Investments are subject to loss.