Summary: ESG Investing Decisions

Environmental, social and governance (ESG) investing is growing in popularity among investors and financial advisors. With this increased popularity comes a growing list of funds and specialized strategies to use in an asset allocation plan. One reason more people are shifting money towards ESG investments is greater research by academic and investment institutions showing potential risk and performance benefits by businesses who implement ESG policies.

As interest in various forms of ESG investing has grown, so has investor confusion around all of these terms. Choosing what to focus on as an investor depends on a number of factors, including your goals, beliefs, resources, and preferences. Though one agreed-upon process to evaluate ESG investing actions may never exist, any proposed process should be practical and help you make informed decisions with both your time and capital.

Creating a decision-making framework helps investors determine what—if anything—they should do about ESG issues. The framework asks investors to establish the goals for potential action; shares what options may be available to help them meet their goals; and articulates how to decide which actions to take, if any, based on the investor’s preferences, beliefs, expertise, resources, and circumstances.

Promoting strong corporate governance, protecting the environment, and encouraging high social standards are on the minds of many investors throughout the world. But many are grappling with whether they should do anything about it within their portfolios. It is important for investors to carefully weigh the decision of whether and how to address ESG-related issues. Many ESG investing approaches are available, and deciding which tool, or set of tools, to use—if any-—depends on a variety of factors. An objective and practical framework can help investors make well-informed decisions through a prudent process that considers their beliefs, preferences, goals, expertise, resources, and circumstances.

FULL ARTICLE:

ESG Investing Decisions

Environmental, social and governance (ESG) investing is growing in popularity among investors and financial advisors. With this increased popularity comes a growing list of funds and specialized strategies to use in an asset allocation plan. One reason more people are shifting money towards ESG investments is greater research by academic and investment institutions showing potential risk and performance benefits by businesses who implement ESG policies.

The goal of this article is not to examine whether certain ESG approaches can meet investor goals. Rather, the focus is to help introduce investors to common ESG terms and ESG investing trends, and to provide a practical framework for what to consider when implementing ESG in your investment portfolio.

Clarifying the confusion

As interest in various forms of ESG investing has grown, so has investor confusion around all of these terms. Choosing what to focus on as an investor depends on a number of factors, including your goals, beliefs, resources, and preferences. Though one agreed-upon process to evaluate ESG investing actions may never exist, any proposed process should be practical and help you make informed decisions with both your time and capital.

Many of the terms used around ESG investing are defined and used differently by academics, practitioners, and the media. While global consensus on definitions may never be achieved, it is important to ground any discussion on the topic by explaining some common terms. The definitions below have been adapted from the Global Sustainable Investment Alliance (GSIA), an international collaboration of membership-based sustainable investment organizations.

ESG investing
An investment-related activity that accounts for some type of environmental, social, or governance consideration. Related terms include: responsible investing, socially responsible investing (SRI), thematic investing, and sustainable investing.

Norms-based screening

A form of exclusionary screen that sets minimum standards for business practice based on companies’ adherence to international norms, such as human rights and corruption.

Example: A religious organization’s investment committee seeks an index vehicle that prohibits the purchase of securities of companies with core businesses involving alcohol, adult entertainment, and biotechnology that contribute to perceived immoral behavior.

Sustainability-themed investing

Investing in organizations that stand to substantially benefit from positive sustainability trends. These trends are often environmentally focused, such as the development of renewable energy sources. While the most popular ESG funds invest in securities based on overall ESG performance, there are also more targeted ESG strategies such as thematic funds investing in specific ESG-related areas, such as sustainable energy development or companies with female leadership.

Social impact bonds (or “pay for success” contracts)

A form of investing that links private capital and governments to improve targeted social outcomes and, ideally, produce government savings.

Green bonds

Debt financing issued by private or government entities for an environmentally friendly project or initiative.

ESG Investing Strategies

Integration: Include financial information important to ESG evaluation that complements standard investment analysis. This does not mean a company will automatically be excluded due to one undesirable activity.

Example: An active manager, who does not have a specific values mandate, considers all traditional and ESG related risks, including litigation, reputational, and regulatory risk, for a publicly traded tobacco company. The manager then decides to overweight the stock, after analysis shows it is trading at an attractive price.

Engaged Ownership: Use of internal or external resources including engagement with companies to discourage undesirable corporate behavior and exercise of voting rights to positively influence corporate policies on ESG-related issues.

Example: After voting against the compensation report of an Australian mining company, an investor meets with the company several times to discuss specific issues. In response to shareholder concerns, the company’s new long-term incentive plan adds a relative performance measure, making maximum compensation targets more difficult to achieve. The company also commits to disclosing more details of the compensation policy.

In addition to constructive dialogue, other possible engagement actions with portfolio companies include:

Joining a coalition or advocacy group
Drafting letters to companies
Sponsor or support shareholder resolutions that enact ESG policies in the corporation

Portfolio Screening: An active or index strategy that selects from a universe of investments that meet specific screening criteria determined by the investor, a hired asset manager or a separate third party. Methods of screening include: exclusionary (negative) screening, which excludes or underweights securities of certain countries, or companies based on specific ESG-related criteria; and inclusionary (positive) screening, which overweight’s or only purchases securities of companies with higher ESG ratings than industry peers (“best in class”) or other investment opportunities.

ESG-related data appear to be moving from the margins to the mainstream, as 90% of S&P 500 companies disclose ESG indicators (G&A, 2020). Heightened investor interest in ESG-related data has been noticed by financial data companies. Large rating agencies and index providers have been some of the most active players buying up smaller firms that provide ESG ratings and research.

This proliferation of data, coupled with growing investor interest and technological advancements, has aided the ability of active managers to integrate material ESG issues into their due diligence process. It also has helped index providers construct a wider set of screened indexes for asset managers to consider tracking to meet potential demand from investors with different moral preferences.

Impact investing Targeted investments, often made in private equity or debt markets, with the dual objective of generating measurable, positive societal and/or environmental impact and a level of financial return. Impact investing is even more targeted — and as the name implies, it tends to explicitly prioritize impact over return (which is unique among ESG strategies). This approach typically seeks to direct fund projects to meet specific social or environmental outcomes, such as constructing low-income housing, water sanitation, or clean energy initiatives.

An example of a targeted investment is a private fund that invests in real estate companies focused on building or renovating apartments and retail property in urban areas to help low-income communities. The fund’s general partners are passionate about this issue and hope to attract investors who feel the same way.

Unlike the traditional exclusionary approach of socially responsible investing, positive screening rewards companies with good ESG qualities with the goal of boosting long-term, risk-adjusted returns. Instead of ruling out Walmart or Target because they sell cigarettes, for example, these companies might be included in such a portfolio because they are among the top four users of solar panels in the United States.

Decision Making Framework

In this section, we provide a decision-making framework to help investors determine what—if anything—they should do about ESG issues. The framework asks investors to establish the goals for potential action; shares what options may be available to help them meet their goals; and articulates how to decide which actions to take, if any, based on the investor’s preferences, beliefs, expertise, resources, and circumstances.

1. Define Goals & Objectives

In order for investors to determine what approaches may be an appropriate option, they must first decide what ESG issue or set of issues they want to address. This decision is not always easy, especially if multiple parties are involved, such as in cases with investment committees. A large and growing list of ESG-related issues may be important to different investors.

The most appropriate potential courses of action will vary, based on the investor’s preferences, beliefs, goals, expertise, resources, and circumstances. Therefore, it is critical that the investor defines the objective before moving to the evaluation step. Generally, investors tend to have one or more of the following objectives for ESG-related issues:

• Satisfy values preference. This is based solely on ethical, moral, religious, humanitarian, political, and/or environmental preferences. For example, even if a company is conducting a commercially legal business activity, an investor may prefer not to co-profit from or finance the firm because the investor considers this activity at odds with his or her values.

• Generate financial benefit. Some investors are interested in an action that they believe will improve their financial results, such as enhancing risk-adjusted return.

• Effect meaningful change. Some investors desire an approach that will lead to positive ESG-related change on an issue that concerns them. For example, they may aspire to influence a change in working conditions for employees of a company in an emerging-market country.

2. Evaluate Options

The next step is to study ways to address the ESG-related goal or set of goals. Importantly, these actions are not necessarily mutually exclusive, meaning that investors can pursue multiple approaches.

ESG integration is when investors who have a system to consider any important ESG issues in their analysis and investment selection process. This practice is not meant to replace common analyzing practices but rather to enhance risk-adjusted returns. Some active investors have been considering ESG-related information in their research process for years or even decades, before the activity became labeled as ESG integration.

3. Decide on action

Once the goal, or set of goals, has been determined and the range of potential options identified and reviewed, the next step is to decide what to do based on the investor’s customized decision-making criteria. The potential trade-offs of ESG-related actions will differ by investor and sometimes will require significant judgment, particularly if the investor has values preferences, such as humanitarian, political, or religious.

Investors must adopt the criteria that is important to them and ensure that their expectations are clear once a decision on whether and what action to take is made.

4. Reassess Periodically

As with any other investment decision, the last step in the process is to periodically monitor and review previous decisions and determine whether the action or inaction still makes sense. Institutional investors and advisors may include this step in some form of written document, with varying levels of detail, to ensure that proper assessments and reporting become a standard practice. If action was taken, the evaluation should be linked to the goals and the criteria used, along with any metrics to be tracked or tasks to be done to measure success.

In cases when screening is chosen, a monitoring step would include checking whether the appropriate companies were included or excluded from the portfolio over the evaluation period. If engagement was chosen, investors should prioritize which companies to communicate with and set time or data driven goals for monitoring progress. Whether action was taken or not, the investor should periodically consider whether their goals and preferences, the options available, or decision-making criteria have changed.

Conclusion

Promoting strong corporate governance, protecting the environment, and encouraging high social standards are on the minds of many investors throughout the world. But many are grappling with whether they should do anything about it within their portfolios. It is important for investors to carefully weigh the decision of whether and how to address ESG-related issues. Many ESG investing approaches are available, and deciding which tool, or set of tools, to use—if any-—depends on a variety of factors. An objective and practical framework can help investors make well-informed decisions through a prudent process that considers their beliefs, preferences, goals, expertise, resources, and circumstances.