ESG Investing - From Fringe To Fashionable
WHAT IS ESG INVESTING?
Even for the earliest proponents of sustainable investing, it’s sudden spike in popularity is surprising, but satisfying.
If there’s one trait nearly everyone shares, it’s a desire to make the world a better place. No wonder there’s so much interest in environmental, social, governance (ESG) investing. Who wouldn’t want to try earning decent if not stellar returns, while contributing – or at least causing less harm – to the greater good?
But what is “the greater good”? What qualifies as a decent return?
Many Names, Multiple Aims
Many, relatively interchangeable terms have been used to describe how to incorporate moral values into your investing. To name a few, there’s ESG, sustainable, impact, and socially responsible investing. We believe ESG investing is currently the most commonly used expression, so it’s the one we’ll use here as well.
Call it what you will, ESG investing is a relatively new and fast-growing field, crowded with opportunities and challenges, perspectives and priorities, words and strategies. So, first things first: We are NOT here to direct your moral compass, or to argue for or against traditional vs. ESG investing. Rather, for those who would like to learn more, we offer objective insights, rooted in evidence-based investing.
An evidence-based outlook helps confirm when a promising theory seems robust in reality. It also suggests when it may not pencil out as hoped for – no matter how well-intended it may be. Equipped with solid evidence in an often emotionally charged arena, you will be better able to make informed choices that best fit you, your personal values, and your financial goals.
Why Choose ESG Investing?
Different investors embrace ESG investing for different reasons. Your own priorities govern which approach best aligns with your goals.
Financial (Value) Priorities: Some investors may not focus on investing “morally,” but may do so anyway if they believe companies with higher ESG rates will deliver higher returns.
Impact (Values) Priorities: Others may not care whether ESG investing translates to higher or lower returns, as long as they can shun “bad” companies and invest in “good” ones.
Blended Priorities: Most investors fall somewhere in between. They want to earn solid returns, or at least not lose money, while investing in principled ways.
How Do We Implement ESG Investing?
Following are ways a fund manager or investment officer may incorporate ESG ratings:
Active Ownership: They may try to improve ESG performance by leveraging their shareholder power to directly influence companies’ strategies and operations. For example, in October 2020, Yale University notified 70 firms managing its funds to expect to be measured on their progress at increasing staff diversity. Will Yale’s actions influence these firms’ HR practices? Time will tell.
Negative Screening: They may explicitly exclude firms with low ESG ratings. (“This company is too ‘wicked’ to belong in our fund.”)
Positive Screening: They may explicitly include firms with high ESG ratings. (“This company is at least ‘good enough’ to belong in our fund.”)
Integration (Inclusion) Strategies: They may integrate ESG ratings into their total fund management strategy. In other words, ESG ratings become one among a number of factors driving if and when to include or exclude a security from the mix.
What Kinds of ESG Investments Are Available?
Investors currently have access to a range of ESG investments that use active ownership, screenings, integration strategies, or a blended approach. Overall, we see three main types.
1. Evidence-Based Investing: Evidence-based fund managers are likely to use broad ESG integration (inclusion) strategies, to complement their funds’ overarching goals. They also may engage in active ownership on behalf of their shareholders. Blending the principles of evidence-based investing with ESG ratings should help investors:
Continue to use sound portfolio construction principles (such as asset allocation, global diversification, and cost control)
Avoid less-efficient tactics (such as picking or avoiding specific stocks or sectors based on forecasts or popular appeal)
Apply ESG accountability as an overlay (judiciously including the best-rated and/or excluding the worst-rated companies within an overall, well-structured portfolio)
2. Socially Responsible Investing (SRI): SRI funds are more likely to prioritize screening strategies (out with the “bad,” in with the “good”), ahead of the tenets of evidence-based investing. Their strategies may involve making security- or sector-specific judgments or forecasts. An SRI fund may appeal to those who don’t mind sacrificing some expected returns if it means they can better align their investments with their personal values.
3. Impact Investing: Impact investors are on a mission to not just invest in a venture, but to become an altruistic partner. For example, if you donate to a GoFundMe® campaign for creating eco-friendly alternatives to plastic water bottles, you’ve just become an impact investor. On a grander scale, wealthy investors may take on private equity or debt structures with an eye toward making a direct impact with their funding. In this context, an impact investor’s highest priority is to fund a cherished cause, with less regard for how the “investment” works out.
Again, names and labels can vary. So, before you invest, read the fine print on what you’re actually buying and how much it’s going to cost you!
Which ESG Investments Are Right for You?
As described above, none of the possibilities are inherently right or wrong. It depends on whether you are more value- or values-driven … or equally both.
Also, ESG investing doesn’t have to be an “all or nothing” proposition. For example, you could use evidence-based ESG or even traditional investing for the core of your portfolio, while participating in impact investing with some of your discretionary income.
Once you’ve chosen your desired approach, how do you find the right investment fit for you? Next, we’ll explore the challenges and opportunities that await today’s ESG investor.
How Do You Quantify a Quality?
As we covered above, some ESG investors may be more values-driven, hoping to best align their investments with their personal beliefs. Others are more value-driven, hoping for higher returns by investing in companies whose sound ESG practices are expected to generate better outcomes.
To varying degrees, investors are increasingly seeking a combination of both:
A 2018 Global Sustainable Investment Alliance review cited investor demand as the leading motivation for sustainable investing.
Morningstar reports the number of sustainable index funds and dollars invested in them have more than doubled in the past three years. As of June 30, 2020, there were more than 500 sustainable index funds managing more than $250 billion around the world.
In December 2020, The Wall Street Journal reported that investors had added a record $27.4 billion into U.S. ESG ETFs alone for the year.
All well and good. But how do we ensure there’s real substance behind the popular appeal? Along with the rise of “green” investing, “greenwashed” investments are sprouting up like weeds. They may claim to be ESG-focused, but a closer look might reveal otherwise.
Academics and practitioners alike are still working on this triple riddle:
1. Data: How do we compel or cajole companies into reporting meaningful ESG data?
2. Ratings: How do we consistently compare and score companies’ ESG data?
3. Application: How do we incorporate ratings into an evidence-based investment strategy?
Differing Data Standards
Arguably the greatest challenge in this still-nascent field is gathering the data needed to measure corporate “goodness.” In a BNP Paribas 2019 ESG Global Survey of institutional investors, participants cited “inconsistent quality of data” as the greatest challenge to ESG investing. As one survey participant commented, “There is lots of data. The challenge is finding the right data in the right format and knowing how to use it.”
At least three hurdles exist:
1. Three Balls to Juggle: First, remember, “ESG” isn’t one thing – it’s three. Governance data has been around the longest, so it’s the most robust. According to the aforementioned survey, generating better corporate environmental and social data is “a key part of the data challenge.” Plus, a company’s overall ESG rating can vary widely, depending on how much weight each component has in the total score.
2. Missing Pieces: Most corporate data reporting remains voluntary. Some requirements are coming into focus. Countries like the U.K., are beginning to require specific data reporting. Plus, activist shareholders are increasingly calling for more robust ESG reporting from the companies they’re invested in. But for now, companies often have wide leeway on what ESG data they choose to report, and how they choose to report it.
3. He Said, She Said: Multiple data providers produce different, sometimes conflicting data. A 2020 Research Affiliates report identified 70 different firms that create or curate ESG ratings data (not including untold numbers of private, one-off, or customized data sets). Each firm may adhere to different standards, or even its own secret sauce.
Gathering dependable data is a challenge for any evidence-based investment approach. But it can be especially daunting when an approach is relatively new and advancing faster than best practices can keep pace with. Bottom line, strong, time-tested data reporting standards remain a work in progress.
Rating Challenges
Once we get ahold of a company’s ESG data, the next step is to use it to score and rank their relative ESG performance.
For this, most investors depend on rating agencies. In its 2020 “Rate the Raters” report, SustainAbility counted more than 600 global ESG raters and rankers as of 2018. That number has grown since then, and each agency brings its own personality to the mix.
Research Affiliates describes three broad categories of ESG rating activities:
1. Fundamental: Some data providers specialize in curating publicly available data, without necessarily creating scores or ratings themselves; they leave that next step to others. Examples include Refinitiv (formerly Thomson-Reuters) and Bloomberg.
2. Comprehensive: A number of rating agencies combine public data with their own analyses, interpretations, and rating methodologies to provide ratings as well as trend reports. Examples include veteran firms such as MSCI and Sustainalytics, as well as newer “algorithmic-focused” firms such as TruValue Labs and RepRisk.
3. Specialized: Some data providers specialize in a particular cause, such as human rights or gender diversity, to serve investors who want to prioritize particular issues.
Given the assorted reviews, a company’s ESG data may receive widely different “thumbs up” or “thumbs down” scores. It often depends on who is doing the rating, and what metrics, weightings and priorities they’re using.
To illustrate, Research Affiliates took a look at Wells Fargo’s year-end 2017 ESG ratings. You may recall, this was a period when the company was in the thick of its notorious account-churning scandal. Two different rating agencies issued very different ESG scores at the time. On a best-to-worst scale of 1.0 to 0.0, one agency gave Wells Fargo an overall ESG score of 0.84; the other gave it a 0.31, in part due to widely divergent social and governance ratings. (Research Affiliates, “What a Difference an ESG Ratings Provider Makes!” January 2020)
It’s not necessarily bad or wrong for different rating companies to rank the same data differently. But the rich variation obligates (and allows) you to find a fit that’s right for you. In other words, if you wish to become an ESG investor, you and your advisor will want to understand what’s really behind different ratings, so you can be selective about which investments best align with your own priorities, values and goals.
Applying the Ratings
There’s one more avenue to explore. How do we balance an investor’s desire to invest “ethically” with our duty to advise clients according to their highest financial interests?
The goal is simple enough: We’d like to achieve both. Existing studies and practical applications suggest we can. Just as we have standard benchmarks/indexes for other purposes (such as tracking U.S. large companies, global bonds, or emerging market real estate), providers have responded to public interest by offering a growing collection of ESG benchmarks for comparing one strategy to another.
That said, we’re still early in the process. By definition, it takes years, if not decades, to determine whether evidence-based theories test out in reality – through bull and bear markets; here and abroad; and across stocks, bonds, and other asset classes. The reality is, evidence-based ESG investing is too new to have this sort of track record.
Where We Stand Today
All things considered, evidence to date suggests there are cost-effective solutions available if you would like to invest more sustainably while still pursuing efficient market returns.
But the same evidence informs us, not all ESG data, ratings, and strategies are created equally. Dimensional Fund Advisors offers a helpful perspective in its October 2020 paper, “The Economics of Climate Change.” While the paper focuses on environmental-related ratings, the conclusions apply broadly across ESG investing.
Investors face voluminous and sometimes contradictory academic evidence,” the authors note, but, “simple, tried-and-true investing principles can help.” These principles include:
Letting relatively efficient markets set the pricing (rather than chasing hot trends)
Having well-defined investment goals
Maintaining broad diversification
Whether you’re investing in ESG or traditional funds, these remain the enduring keys to a successful investment experience. They are the touchstones for navigating the uncertainty inherent in any fast-moving trend.
So, yes, ESG investment challenges remain – and probably always will. That’s where we can assist. We’ll help you clearly define your highest financial goals in the context of your personal values. By positioning you to compare and contrast the practical costs and benefits involved, we can empower you to invest in the right ESG solution for you.
Whether you’d like to get started right away, or simply remain informed, we stand ready to respond.
Call us anytime to continue the conversation.
The information provided here is for general information only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. Past performance is no guarantee of future results.
Socially Responsible Investing (SRI) / Environmental Social Governance (ESG) investing has certain risks based on the fact that the criteria excludes securities of certain issuers for non-financial reasons and, therefore, investors may forgo some market opportunities and the universe of investments available will be smaller.