Pursuing ESG: Adding Environmental, Social, and Governance Factors
With the growing popularity of index funds and ETFs, investors are often seeking a low cost approach to a diversified portfolio. And let’s face it, these products, coupled with technology advances in financial services, are allowing ordinary investors to build meaningful wealth in an accessible way. Now, contrast these take-it-or-leave-it products in an age where many people are willing to pay a premium to ensure their coffee/chocolate/soap/t-shirt/apples do not exploit their fellow humans or the environment. A consumer can avoid patronizing stores that do not uphold their values, but investors still have limited options when it comes to values-based investing.
ESG integration is the most recent buzzword used to describe how we incorporate our values in our investment portfolio. ESG stands for Environmental, Social, and Governance — these are the criteria used to classify investments and companies that positively impact their communities. Let’s break this down a little further.
Environmental criteria used to evaluate companies include: carbon emissions, water conservation, pollution, natural resource extraction, and animal treatment. These criteria can impact a number of industries, from agriculture production to utilities, oil and gas exploration, and plastics manufacturing.
Social criteria may address human rights, worker treatment, and operations in conflict zones.
Governance criteria have been most widely accepted in asset management, seeking to lower portfolio risk by selecting companies with increased diversity in boards and executive leadership, fair executive pay standards, anti-corruption policies, fair tax-paying practices, and heightened cyber security.
You may have heard of ESG’s predecessors: Socially Responsible Investing (SRI), impact investing (#impinv), sustainable investing, or responsible investing. This landscape has changed over time to incorporate new meaning, but the various definitions also help highlight that standardized best practices are limited at this point.
Selecting investments that excel in meeting ESG criteria standards is becoming more popular among institutions, socially conscious individuals, and younger investors. Unfortunately, without uniform standards in place, these criteria, and how we measure investments based on them, can vary. These days, you can select index funds that are screened for ESG criteria. The more specific you intend to drill down on these criteria, the more your investment strategy verges on active management, and the harder it becomes to meet your value-based goals while maintaining a cost effective portfolio.
So how are thought leaders incorporating ESG criteria into portfolio construction? The most basic and longest-standing method is to use restrictive screening to screen out unfavorable companies or investments. Common screens eliminate companies that operate tobacco, weapons, casinos, or from your portfolio. ESG screens are becoming available in more index funds, allowing some lower cost options to gain exposure to ESG. A second option for ESG integration is thematic investing.
Instead of screening out negative characteristics, you increase exposure to promising investments with favorable fundamentals and adequate exposure to ESG themes. Thematic investing is typically considered more active in strategy, meaning that you try to pick quality investments to obtain a competitive risk-adjusted return.
More and more investors and institutions are seeking ways to integrate their social values into their investments. As more products and strategies become available, it has become easier to find competitive risk-adjusted performance with investments aligned with investors’ beliefs and values.