Many investors wonder how they can better align their portfolios to their values—and if they can do so without sacrificing potential returns. The good news is that high-quality investments tend to go hand-in-hand with responsible business practice and environmental, social, and governance (ESG) factors. But while it’s possible to have winning investments that also embody a responsible portfolio, there are many factors that could impact your outcomes, such as core personal values, the way you prioritize certain ESG factors, and subsequent responsible investing strategies.
In this article we’ll provide an overview of responsible investing, introduce the concept of ESG factors, explain what makes this a complex environment, and provide some insights on the variety of strategies available.
Understanding responsible investing
Responsible investing is a broad, umbrella term that describes any investment strategy that explicitly considers one or more ESG issues in the investment decision process. That is, do the funds you invest in prioritize and comply with a clearly stated ESG framework. The variety of common monikers—such as ethical investing, socially responsible investing, and sustainable investing—have made it challenging for investors to navigate this space. Adding to these difficulties, is the fact that responsible investing can involve many different strategies with a variety of different intended outcomes. However, at its foundation, responsible investing recognizes that the consideration of ESG factors can play an important part in fully understanding risk, opportunities and the true value of an investment.
What are ESG factors?
Since responsible investing strategies all involve some level of ESG factor consideration, it’s helpful to familiarize ourselves with them to get a better understanding of how they play a role in the investment process.
Environmental factors consider how a company’s business operations impact the natural environment such as pollution and emissions. They also consider how a company’s operations could be affected by the environment (the impacts of water scarcity for an agricultural company as an example). With an increasing societal recognition of the impacts associated with environmental degradation, polluters or those with poor sustainability face increasing risks associated with changing regulations and consumer preferences. In contrast, companies with less negative impact, those that are becoming more sustainable, and those that are benefiting the environment, may have more positive prospects.
Social factors involve the relationship between a company and their customers, employees, suppliers and communities. Mismanagement of these key relationships can carry significant financial risks including litigation or alienating consumers and employees. Well-managed relationships can foster high employee engagement, retention of top talent, robust supply chains and loyal customers while also contributing to positive social change.
Governance factors involve the systems, policies and oversights in place to ensure that a company is appropriately managed and that shareholders are protected. Firms that engage in ethical and appropriate corporate behavior are more likely to benefit from greater investor and stakeholder trust, reduced risk of scandal or fraud, as well as operational efficiencies.
The importance of ESG factors
Depending on the goals of the investor and the particular responsible investing strategies used, considering ESG factors can help align a portfolio to an investor’s values and contribute to measurable environmental and social outcomes. More broadly, analysis of ESG factors can also provide investors with valuable information to be able to better understand potential risks and long-term prospects of a company’s business. Though a positive or improving ESG track record can certainly create value for a business, examples of negative track records provide a more obvious illustration of how investors can be impacted.
Negative behavior around ESG issues not only can cause societal harm but can also hurt shareholder value. Memorable instances include BP’s Deepwater Horizon oil spill, Volkwagen’s diesel emission scandal, and SNC Lavalin's fraud and bribery charges—all of which ended up causing serious reputational and financial losses for the companies, which negatively affected shareholders in the process. By looking at a company’s ESG track record, fund managers and investors may be better positioned to flag potential risks which can then be factored into their decision-making process—whether that’s avoiding the company altogether or simply ascribing a more accurate valuation to the company that will influence the price they’d be willing to pay.
Responsible investing strategies
Individuals have unique preferences, values and investment objectives, which require the implementation of different strategies. Some responsible investment strategies focus exclusively on financial returns and consider ESG issues that could impact these while others place greater emphasis on value alignment and achieving positive outcomes for people and the planet, while avoiding negative ones. The strategies below are not mutually exclusive and investment funds may include multiple strategies within their objectives. It's worth noting that many fund managers consider ESG factors in some respect as part of their due diligence process, even if their funds don’t have an explicit mandate to do so.
ESG integration and evaluation
This strategy involves thorough and deliberate consideration and analysis of ESG criteria as part of the investment-decision making process for all securities within a fund.
ESG exclusions (negative screening)
This strategy makes investment exclusions based on specific sectors, industries, materials, or companies based on ESG criteria or other specific ethical considerations. These exclusions can vary depending on the fund in attempts to appeal to a variety of different investor values (eg. companies whose business is primarily involved in alcohol, tobacco, firearms and weapons, gambling, fossil fuels, etc.).
ESG best in class (positive screening)
This strategy generally involves investing in securities that are identified in having better-than-average ESG metrics and track records compared to their industry peers.
Active engagement and stewardship
Funds with this strategy seek to generate positive ESG outcomes by leveraging their ownership positions of the companies they hold. This can include a variety of activities such as engaging directly with company management on ESG concerns, supporting ESG issues through proxy voting and advocating for public policy measures.
In addition to financial returns, a key outcome of these strategies is to have a measurable positive environmental or social impact. This can be achieved through initiatives such as investment in social enterprises, lifesaving medicines, social housing and access to education, or by charitable donation of some portion of the fund to impactful projects.
In general, thematic strategies identify disruptive themes and seek to invest in companies that stand to benefit from them through products and services. They typically have a specific focus on a particular ESG-related theme without focusing on the entire spectrum. This could include environmental themes such as renewable energy and climate innovation, or social themes such as gender diversity and health and wellness.
The responsible investment and ESG landscape continues to mature and evolve and is expected to become more deeply integrated across the investment industry. As an investor, having an understanding of the basic terminologies, strategies, and desired outcomes, is an important step in your efforts to align your portfolio with your goals and values.
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