I am often asked “What is SRI?” or variations such as ESG Investing, Sustainable Investing, Mission-based Investing, Responsible Investing, Ethical Investing, Green Investing, Impact Investing or Socially Responsible Investing. Whatever the name, SRI is an approach to investing that recognizes the generation of long-term sustainable returns is dependent on sustainable companies and capital markets. More importantly, SRI explicitly acknowledges the relevance of environmental, social and governance (ESG) factors to financial returns.
According to US SIF, SRI Investing continues to grow with $8.72 trillion assets under management as of the beginning of 2016. A decade ago there was less than $1 tillion invested in SRI strategies. There are several trends behind this significant growth, certainly in the last few years. Investment Advisors, Multi-Family Offices and Institutional Investors are increasingly incorporating SRI and ESG factors into their investments analysis and portfolio construction. Recently, firms like Goldman Sachs and BlackRock launched major product initiatives in this field which has led to a greater awareness on Wall Street of the importance and client demand for increased SRI engagement. Another reason has been due to the growth of the UN Principles for Responsible Investment (PRI). The PRI initiative is an international network of investors working together to put the six Principles for Responsible Investment into practice. As of today, there are over 1’700 signatories which include asset owners, investment managers and service providers.
There are 6 key SRI strategies which include:
- Negative Screening: the exclusion of assets based on ESG criteria
- Positive Screening: the inclusion of best-in-class assets based on ESG criteria
- ESG Integration: the systematic and explicit inclusion of ESG data into investment decisions
- Impact Investing: targeted investments aimed at solving social or environmental problems
- Engagement: which is active engagement with company management around ESG issues (selective or overlay)
- Thematic Investing: the selection of assets based on their categorization under certain sustainability themes (e.g. renewables).
Negative Screening is the traditional and most common approach which excludes individual companies or entire industries from portfolios if their areas of activity conflict with an investor’s values. This process can be quite flexible as it can rely either on standard sets of exclusion criteria or be tailored to investor preferences. For instance, investors may wish to exclude companies with sales generated from alcohol, weapons, tobacco, adult entertainment or gambling – so-called “sin stocks.” Some faith-based investors also exclude companies involved in contraception and abortion-related activities.
In the case of government bonds, investors may seek to avoid an entire country based on the sovereign’s compliance with select international standards (e.g. human rights or labor standards). In general, one of the major criticisms of this approach is that it reduces the investable universe.
Positive screening seeks to identify companies working towards social or environmental good. This screening uses ESG performance criteria and financial characteristics to select the best companies within an industry or sector, usually relying on a sustainability rating framework. This is usually a more knowledge-intensive process than exclusionary screening because it requires understanding which factors are relevant for each industry and evaluating individual issuers on each of these factors.
ESG integration, unlike positive screening, seeks to incorporate material ESG risks and growth opportunities directly into traditional security valuation (e.g., through inputs such as earnings, growth or discount rates) and portfolio construction. This approach has gained traction in recent years and is based on the premise that additional ESG information not covered by traditional analysis could have an impact on the long-term financial performance of a company. ESG integration involves understanding how companies handle social, environmental and governance risks that could damage their reputations and whether they are positioned to capture ESG opportunities that could give them a competitive edge.
Impact investing explicitly seeks to generate a positive social or environmental impact alongside a financial return, unlike other SRI approaches, where progress on social and environmental issues may be a by-product of financial enterprise. The niche market of impact investing is growing fast. Examples include community investing, variants of microfinance, as well as private equity-like deals investing in such sectors as education, healthcare, basic infrastructure and clean energy.
Shareholder Engagement recognizes that as a shareholder of a company, investors have the ability to take an active part in the governance and activity a company employs. Shareholder influence attempts to shift corporate behavior toward greater compliance with ESG principles. Influence can be exerted by investors through direct communication with corporate management or by filing shareholder proposals and proxy voting. The influence of shareholder engagement on ESG issues has risen in recent years. The majority of the proposals filed have been focused on political activities of corporations, the environment, human rights/diversity, and governance.
Thematic Investing targets specific themes such as climate change, water, human rights or gender lens investing. For instance, using a gender lens to empower women would evaluate companies and investment opportunities based on women’s leadership, women’s access to capital, products and services beneficial to women and girls and workplace equity.
A common concern about SRI investing is that there is a premium to be paid for making responsible investments that would naturally diminish investment returns. For instance, by applying an exclusionary screen the available investable universe is reduced and thus this could have a negative impact on returns. Given that there are many different SRI strategies, making comparisons becomes more challenging. For example, shareholder engagement in single stocks might create long-term value but what benchmark would this be compared to?
Thus, an investor may choose to add value(s) to investing in order to achieve a positive environmental or social impact alongside financial returns; align investments with values and core beliefs; and improve portfolio risk/return characteristics by factoring sustainability into investment decisions. The way an investor can implement this objective would be to:
- Develop a beliefs statement regarding ESG integration and sustainability
- Update Investment Policy with ESG Policy
- Develop asset allocation strategy in line with the ESG Policy
- Implement changes in the portfolio
- Manage and monitor the portfolio.
SRI investing does raise strong emotions and disputes from both sides of the debate. Opponents to SRI are opposed to anything other than financial factors affecting the value of a security. Likewise, some advocates for SRI have such deep moral convictions that they cannot imagine the possibility that the integration of ESG factors could have anything but a positive effect on investment returns. The challenge therefore is to ignore the emotion based in pre-conceived beliefs coming from these opposing views and rather focus on the facts.
Ultimately, I believe there is an important value added in helping our clients identify the core values that are important to them and creating an investment strategy that empowers those values.
Column by Philip Carey