By Matthew McKee, CFA, CFP®
July 18, 2022
When we think about investing, most of us think about returns. But have you thought about how it impacts the world around you? The dollars we invest in a company provide funding, whether, in equity or debt, that enables a company to operate. By directing those dollars to companies that align with our values, we not only invest for our future but a future that aligns with our vision for it.
In part, investor demand for this alignment of values has given rise to the growing popularity of sustainable investing over the last couple of decades. A 2019 survey by Morningstar showed that 72% of Americans surveyed expressed interest in sustainable investing. As such, more and more investors are incorporating ESG analysis into their investing framework. According to the US SIF Foundation, of the $51 trillion in professionally managed assets as of year-end 2019, $17 trillion had an ESG incorporated into the investment selection process.
So what is sustainable investing?
Sustainable investing, most commonly known as “ESG Investing” focuses on the “Environmental, Social, and Governance” characteristics of companies. While many of us think of renewable energy when we think of sustainable investing, ESG covers a much more comprehensive range of issues.
Environmental, in addition to renewable energy, also includes issues such as water, waste management, and biodiversity. Social problems are related to how a company treats not only its shareholders but all stakeholders – employee relations, human rights, and community relations, for example. And Governance focuses on board management practices, diversity, regulatory compliance, and fraud.
Many also think of ESG investing as excluding specific industries. However, it is frequently more complex and relative. For example, while some are exclusionary, such as avoiding companies in industries like alcohol, tobacco, guns, and more (known as “sin stocks”), others are inclusionary – investing in all sectors but focusing on the top ESG-ranked companies within each. And other investment managers actively engage with the companies they invest in to promote ESG awareness.
As you’ll probably guess, it is also hard to quantify some ESG criteria. While several rating agencies grade companies on these metrics, such as MSCI ESG Stats, Corporate Knights, and Sustainalytics, no standardized ESG grading system exists. This is one of the category’s primary hurdles and makes the investor’s job in determining how they are investing a little more complicated.
What does ESG mean for investment returns?
Neoclassical economic theory assumes the role of a firm is to maximize shareholder value. Therefore, in the early years of ESG investing, it was commonly believed that by focusing on companies with favorable ESG attributes, and not just those maximizing the bottom line, you would sacrifice return.
On the contrary, investors have benefited by incorporating ESG analysis into their investment selection process. A study by Morgan Stanley Institute for Sustainable Investing compared the performance of ESG-focused mutual funds and ETFs. Not only did it show there was no trade-off in returns, but it found that they had lower downside risk and were more stable in periods of extreme volatility.
Another academic study compared 180 US companies – 90 considered “High Sustainability” and 90 deemed “Low Sustainability.” The authors found that the High Sustainability companies were more likely to have top executive compensation incentives aligned with sustainability metrics. They were also more likely to have established processes for stakeholder engagement, be more long-term oriented, and showed evidence that they significantly outperformed their Low Sustainability counterparts over the long term.
It might seem counterintuitive that companies not purely focused on their bottom line perform better than those that do. Companies that concentrate on ESG criteria may be seen as less risky, have a competitive advantage, and have a better reputation. While these may seem like niceties that don’t matter, their lower risk profiles can lower the company’s cost of capital, thereby increasing its valuation.
So if ESG doesn’t hurt (and may help) investment performance, how do I implement it?
Many investment products are ESG-focused. But again, the devil is in the details, and due to the lack of standardization, there is a wide range of what that means and how it is actually put into practice. For example, many mutual fund managers incorporate ESG analysis into their investment selection process. And on the passive side, many ETFs espouse their sustainability. Yet it’s essential to understand how the ESG framework is implemented and what that means for your portfolio’s exposure.
How much the asset manager focuses on ESG impacts how closely tracks the benchmark. This is important to understand as it relates to how much risk you take as an investor. Some ETFs rank companies within each sector and maintain a similar exposure to the index. Others may have stricter ESG parameters but will deviate more across exposure.
Unfortunately, the lack of standardization puts a lot more work on the individual investor to understand how the investment decisions are made and what that means for risk and return. While there is no single best way to implement this investing practice or a standardized framework, ESG can be a great way to align your investment dollars with your values and help positively impact the world around you. If you’d like to discuss this, please feel free to reach out.