Have you heard of environmental, social and governance (ESG) investing?
Some label it as a trend but the reality is that over the past 15 years, technological capabilities have increased to allow more transparency over company business practices. There has been a significant and steady rise of money into ESG investments.
ESG relates to three key pillars:
• Environment. This type of investing relates to how a company performs in relation to the environment. Therefore, their carbon footprint, water and energy usage, and waste created as a result of operating a business may be factors.
• Social. This tends to be associated with how a company operates in relation to both their internal and external stakeholders. Examples include gender and diversity policies, human rights and labor standards, employee engagement and benefits.
• Governance. This type of investing examines the board and management’s corporate practices. This may include business ethics, board and executive compensation, bribery and corruption policies, lobbying and political activities.
According to the Forum for Sustainable and Responsible Investment, 26 percent of every dollar under professional management in the U.S. is devoted to ESG investing. On top of that, between 2011 and 2018, companies reporting on their ESG performance skyrocketed from under 20 percent to 86 percent. ESG is also getting more attention on quarterly earnings calls. Per Factset, almost all companies that cited ESG on their earnings calls discussed their own corporate ESG initiatives and reporting or discussed ESG-related businesses, products, or services.
In the past, responsible investing centered on exclusionary screening — if the investor didn’t agree with a company’s business practices, such as tobacco, weapons or oil, they would not invest. This has evolved to be more sophisticated and can include anything from investing in companies which would impact the communities in which they do business to investing to impact a certain environmental outcome.
Choosing “responsible” investments
Each investor is different and those interested in ESG will have varying opinions on what percentage of their assets they wish to invest in a particular company or fund.
Investors choosing an ESG fund have access to fund holdings, so it’s known which companies are being invested in. At the fund level, managers who have been involved in responsible investing typically have a clearly defined process to identify ESG-worthy companies to put in their portfolios. These managers have a solid research team and robust data analytics to identify companies exhibiting good ESG behavior.
The challenge still remains finding suitable companies to make a well diversified ESG portfolio. While there are a number of specialty funds in the space, many tend to focus on the “E” aspect of ESG: Clean energy, water resources and no fossil fuels, for example, and not as much on social or governance issues. Also, some environmentally-focused funds can be specialized to the point of removing diversification and adding volatility to a portfolio. On top of that, many of these companies are highly-dependent on federal funding support and consumer trends which can change year to year.
Therefore, while an individual is investing directly in an area they feel strongly about, it’s not always the best investment approach.
Exclusionary or negative screening still plays a role in ESG. Two recent examples highlight how investors reacted to companies which weren’t exhibiting responsible business practices:
• The opioid epidemic continues to plague families and communities across the country. Several health care distributors have been involved in litigation from not doing enough to prevent the onset of the epidemic. These firms have experienced significant divestments of their stock.
• When a large US bank was caught opening phantom accounts to boost reported sales of their services, an ESG manager used their investment to vote their proxy shares according to responsible practices. They also opened dialogue with bank leadership for broader change at the company. This seemed like a positive step in the right direction, but when governance changes fell short and additional problems came to light, the manager sold all their shares.
Who’s investing in ESG investments?
According to a 2017 report from the Institute for Sustainable Investing’s “Sustainable Signals,” by 2025 Millennials are expected to make up 75 percent of the American workforce with 31 percent having a 401(k). In the report, 9 out of 10 Millennials expressed interest in having sustainable investments in their portfolio.
In addition, Millennials are significantly more likely to work at a company that has a social or environmental viewpoint in line with their own. Many companies offer direct stock purchase plans to employees where shares can be bought with small paycheck deductions. This likely means Millennials are making their sustainable investments through their employer’s stock and by available 401(k) options.
Building ESG into your portfolio
Investors can access funds of traditional managers to develop an ESG solution that aligns with their financial goals. There are a number of investment managers with track records of investing responsibly for a number of decades.
Most investments made by ESG managers are tied to companies with established businesses. This helps managers see a timeline of the company’s decision making to determine if a prospective business meets ESG criteria and is worthy of investment. History can provide a timeline of whether or not a company has been a good steward in the past and if they have improved their ways. It also can shed light on companies that start out with the best intensions but end up falling short.
ESG investing is a worthwhile cause that can build your portfolio while literally putting your money where your mouth is. For those interested in ESG investments, a current or prospective client should speak to their advisor and determine how this type of investment approach would best complement their current financial plan.