Editorial Note: This post originally appeared on the Helping Advisors Blog on March 31, 2016.
To many, ESG brings back memories of Socially Responsible Investing (SRI) – which has typically employed an exclusionary screening based on social issues rather than investment issues. For example, electing to divest or not invest in: “Sin stocks,” like alcohol, tobacco, or pornography; or South African companies during the Anti-Apartheid Movement (originally known as the Boycott Movement) of the ‘70s and ‘80s; or fossil fuels today. Although on the face of it the two investment approaches may sound similar, I’m here to tell you that today’s ESG investing is not your father’s SRI.
What is ESG investing?
ESG refers to environmental, social, and governance issues that an investor may consider when making investment decisions. Examples of ESG issues, include:
- climate change, air pollution, energy efficiency (‘Environment’ issues);
- gender and diversity, human rights, labor standards (‘Social’ issues);
- board composition, executive compensation, whistleblower schemes (‘Governance’ issues).
What is the appeal of ESG-focused products?
Many investors around the globe are interested not only in the financial outcomes of their investments – but also the impact their investments may have and the role their assets can play in promoting certain global issues. Such investors often cite a sense of responsibility to do good, socially and environmentally.
One generation increasingly interested in ESG investing is millennials. According to the 2006 Cone Millennial Cause Study,1 the majority of this generation is more likely to trust a company or purchase a company’s products when the company is considered socially or environmentally responsible. Conversely, roughly half of Millennials surveyed are more likely to refuse a product or service from a company who is considered socially or environmentally irresponsible.
How should advisors consider weighting ESG criteria relative to other product attributes and characteristics?
While some investors may want their portfolio to reflect their own convictions about important global issues, others may see ESG as a potential way to impact investments positively. Either way, ESG considerations should not serve as a substitute for typical due diligence about the investment process of an investment. Rather, they can serve as a complement.
In addition, the implementation of ESG is more sophisticated than SRI. A limiting feature of SRI screens was that they typically were not investment-based. Rather, securities that did not meet some social or environmental criteria tended to be stripped out of the portfolio, without consideration for the investment implications. While the portfolios were deemed socially responsible, they often did not meet investor expectations for returns and therefore earned a sub-par reputation.
Recently, some of my colleagues published research which shows that active managers’ intent to add long-term value through security selection is leading many of them to ESG-type securities. While the manager may or may not be purposefully screening for ESG factors, their investment criteria often identifies securities which result in significant ESG tilts. This may indicate, from an investment standpoint, that ESG includes risks not normally included in financial statement analysis, and active managers are looking more holistically at security-level risks.
Factoring environmental, social, and governance issues into investment processes could be another source of insight into security selection. The key is to start with good portfolio management and focus on outcomes. In fact, clients interested in seeking a positive tilt toward ESG factors in their portfolios may find that their active products already have one. Many different service providers are now providing ESG rankings for funds. We suggest advisors use these tools to help monitor their clients’ investments. (You may be pleasantly surprised at the ranks). And remember, today’s ESG investing is not your father’s SRI.
1 Source: Cone. (2006). The Millennial Generation: Pro-Social and empowered to Change the World. The 2006 Cone Millennial Cause Study.
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