In a constantly changing world where information is readily available, many individuals are now more aware of how their personal decisions impact the world around them. Using more reusable products and reducing waste are small-scale examples of how some act on this awareness.
But what about in the financial market? Is it possible to act on social and sustainable awareness while also saving for the long-term future?
New investment strategies have emerged as a result of this growing awareness to satisfy those exact questions.
Beyond traditional investments
The first glimpse of ethical investing began in the 1980s when more socially conscious investors decided that because they had strong opinions on certain companies or businesses that they did not morally support, they did not want to fiscally support those companies through their funds. These investors wanted to make sure the investments they chose aligned with their moral values, thus leading to an investment style known as an ethics-based approach. What started as a faith-based investment platform has expanded to encompass much more.
Today, broader groups and ideas such as environmental, social and/or corporate governance (often referred to as an ESG framework) investing have emerged to create a whole new approach.
The ESG framework focuses on evaluating a company’s practices in three specific areas:
Environmental: Environmental investing looks at a company’s approach to being sustainable and environmentally friendly. This framework focuses on answering an important question: How do the companies that investors invest in help or hinder the sustainability of the resources for next generations?
This type of investing typically screens businesses to determine what environmental strides they take and what efforts they make to reduce their carbon footprint.1 When screening for environmental awareness, issues that could be looked at include greenhouse gas emissions, operational waste by the plants of the company, and even potential toxic spills and releases that the company may have had in the past.
Social: Social investing looks more specifically at ethical views and/or beliefs that the investor may have. This can involve excluding companies that have a social impact that an investor may feel strongly against, such as excluding tobacco or alcohol companies. Alternatively, individuals may also proactively invest in companies that the investor believes to have a positive social impact. They create their framework around excluding or including these social values into their portfolio and invest accordingly in companies that mirror these values.
Governance: With regard to corporate governance investing, the focus is on how a company looks to compose its leadership and business practices in order to provide transparency to investors. By looking at the board of directors and its makeup, both in the diversity of its members and independence to make decisions that are in the best interest of the company, individuals can determine whether they think that company is one that they would like to invest in.
Companies that have a strong corporate governance track record will have a level of independence between high-paid executives and the board so that decisions such as compensation are not swayed by the executives. A board with more diverse members will offer different insights and points of view that would allow the company to make better decisions. Additionally, corporate governance screens may explore what voting rights shareholders are given to make sure investors’ voices are heard.
According to the Harvard Business Review, in 2010, there were about $3 trillion dedicated to investing in ESG strategies. In the beginning of 2018, that number grew to be $11.6 trillion of professionally managed assets. More staggering, that figure accounts for $1 of every $4 that is invested in the United States.2 With a large influx of requests for additional security screening, fund managers have had to adapt and grow to accommodate their investors. Managers such as Aperio have grown to specialize in creating portfolios of securities that match the unique ESG filters of each investor.
Building an unique portfolio
Two strategies that managers may use to construct sustainable portfolios are through positive and negative screens.
To understand how these portfolios are constructed, think of the entire portfolio as a symphony orchestra. With negative screens, as the name might suggest, a sustainable portfolio manager would look to reduce the weights of certain holdings or remove the holdings entirely — oil companies or firearms manufacturers as an example. In a similar manner, the conductor of an orchestra may choose to make the orchestra less full-sounding by reducing the number of players in order to best match the intended mood for a piece of music.
Conversely, a positive screening process looks to emphasize or include companies that best illustrate sustainable values. Within the finance industry, for example, companies that have a history of strong corporate governance could be preferred over those that have a weaker track record. In the context of an orchestra, this could be when a particular instrument section is highlighted in a piece of music.
In both cases, the end goal is to create a positive experience for the intended audience. Similar to how a conductor reducing the number of players does not change the intended goal for a specific piece of music, constructing a sustainable portfolio does not necessarily mean changing the goal of earning positive market returns.
When you look at traditional socially conscious investing portfolios, the screens would typically be mostly negative, as these types of portfolios would look to exclude some companies based on values. As the approach to values-based investing has evolved, more sophisticated ESG approaches now use a mix of both negative and positive screens, depending on what funds or securities make up the portfolio.
Looking at market returns
Discussing ESG investing strategies often presents a logical question: How will this approach affect returns? While it’s true that ESG portfolios do not traditionally mirror the overall markets, portfolio and fund managers, such as Aperio or Dimensional, have worked to use research in their objective to minimize risk while maximizing returns, while reflecting the values that are important to socially and sustainably minded investors.
In the past, funds with a sustainable focus may have looked to prioritize investments in specific values over maximizing returns. Today fund managers are able to keep these additional considerations in mind while also looking to generate comparable investment returns to the overall market.
The advancement of data and research available to fund managers has helped these managers work towards market returns without sacrificing the values that the investor holds dear. Firms like Bloomberg, MSCI, Morningstar and Reuters can now collect a myriad of datapoints specific to socially conscious and sustainable sensibilities, making it easier for funds to incorporate these datapoints into the investment process.
Businesses have also started to voluntarily disclose governance and sustainability data. The Governance & Accountability Institute found that 86% of the companies within the S&P 500 index published sustainability or corporate responsibility reports in 2018, an increase from 2011 when that figure was roughly 20%.3 Investment analysts can use this data to incorporate additional risks that may not traditionally be considered, such as the impact of climate change, or provide a more nuanced approach to portfolio construction.
Challenges remain, including the consistency of sustainability data being reported by different groups. There are also a number of different standards available for asset managers to sign onto, including the United Nations Principles for Responsible Investing (PRI) and the U.K. Stewardship code, among others.
While this helps firms commit to implementing a sustainable framework, the typically broad nature of these guidelines means firms can interpret them in different ways and creates a lack of consistency in ESG approaches. However, overall the continued growth and advancement in the ESG space have made it easier for investors to create well-diversified portfolios that align to both their values and investment objectives.
It’s important for investors interested in this type of approach to first think about what values are most important to them. Being able to invest in a way that can reflect the values that an investor holds can give you greater peace of mind.