Addressing Trade-offs in Your ESG Strategy
Updated: Mar 30, 2020
Socially conscious individuals are drawn to the idea of socially responsible investments (SRI), allowing them to align their social values with their investment dollars. There’s no one-size-fits-all approach to this, and most retail investors will need to consider trade-offs to find a solution that ultimately meets their investment needs and social impact goals. The trade-offs are extensive, from diversification, to variability in social values, to investment costs and accessibility. Here are some of the trade-offs investors will need to consider when making decisions to incorporate socially responsible investments in their portfolios.
Investors may be considering investments in environmental sustainability to help combat climate change. Environmental sustainability investments may incorporate renewable energy generation through solar or wind. However, to shift your entire portfolio to renewable energy or environmental sustainability may unfavorably concentrate your investments in a single sector. In the event of a market downturn, or the development of a new alternative energy, this concentration may have a negative impact on your nest egg. To avoid this concentration risk, investors need to consider diversifying by region, sector, and company size to achieve competitive rates of return.
Many passive Environmental Social Governance (ESG) or Socially Responsible Investing (SRI) investment vehicles attempt to screen out negative impact companies. On the bright side, investors avoid the worst of the worst. Although screening can be a cost effective strategy to align your portfolio with your values, this may not tip your portfolio weighting to the most positive impact companies. As a result, many of your investments may fall into a neutral category, which does not deliver the overall positive impact some investors are seeking.
MEETING INDIVIDUAL PREFERENCES AND BELIEFS
Meeting individual’s preferences and beliefs: Socially Responsible Investing was first introduced centuries ago to meet the needs of faith-based organizations. Today, there are many investment vehicles that continue to cater to Catholic values, meaning they are pro-Life, anti-weapons, and do not engage in weapons, tobacco, alcohol, or gambling. These social values may meet some investors’ preferences and beliefs, but they could be misaligned for someone else who wants to emphasize gender diversity or social justice issues in their investments. The more specific an investor becomes in their preferences and beliefs, the more difficult it becomes to deliver a cost-effective, diversified portfolio.
These days, diversified ESG and SRI products are available for investors at low cost by implementing passive index strategies. Some products use analysis to evaluate the environmental, social, and governance factors that affect a particular company included in a fund. This analysis, coupled with fund management, tend to increase investment costs, which can eat away at your investment returns. This can be a double edge sword, because if you look to lower costs by moving into a passive strategy, you may lose out on social impact.
Many investors who express interest in SRI are told that they have to sacrifice returns to incorporate their social values into their portfolio. That argument is somewhat outdated, as studies show that companies with greater gender diversity have better performance and larger, more stable companies can allocate more resources to sustainability initiatives. That said, screening out negative ESG investments may have a negative impact on overall returns. After all, you may be screening out some particularly profitable companies. Additionally, by screening out certain companies in investments, performance tends to vary from an index. This variability may encourage investors to pursue more active management, which can increase costs and lower overall return. Basically, performance can vary by strategy, making it more difficult to outperform a benchmark or index. Investors should be comfortable with competitive returns, while accepting that their socially conscious investments may not deliver a higher expected return compared with other investments.
Some investors wish to incorporate SRI into every facet of their portfolio. This may be difficult to achieve, depending on the investment options available in employer provided qualified retirement plans. Additionally, some SRI opportunities, although intriguing, may only be available to accredited investors, so only high net worth individuals have the opportunity to invest. For this reason, investors may have limited opportunity to invest in SRI. They may consider rolling over retirement assets to an IRA or just dedicating a portion of their investments to SRI.
It’s difficult to deliver a diversified portfolio tailored to an individual’s social values with a high level of impact in a cost effective way. Retail investors may be more limited by investment options in their qualified retirement plans or investment options available given the size of their portfolio. All in all, it’s important for individuals looking to invest in socially responsible investments to understand some of the trade-offs they’ll need to consider when investing in this space.
Investments are just one component of your entire financial picture. Similarly, investments are just one component of your social impact picture. Investors are encouraged to navigate these trade-offs to determine what’s right for their needs. But to be realistic, you may need to supplement your socially responsible investments with charitable and philanthropic giving, political action, or community organizing to create a complete picture of your social values.