Investing Basics: The ABC of ESG

 

Ethical or socially responsible investing

 
The first category is ‘ethical investing’, also described as socially responsible investing. This approach is not new – in fact, the concept dates back to guidelines specified by religious organisations more than 100 years ago regarding what was acceptable to invest in.

That basic structure is still in practice today, and most strategies are built on an opportunity-set that excludes investments in enterprises deemed as morally deficient (often referred to as ‘sin stocks’). Typical examples would include alcohol, firearms, gambling, and pornography.

The primary value to investors is the knowledge their capital is not backing something they would feel uncomfortable with. This is an increasingly important consideration for investors and there are socially responsible versions of many core investment strategies available in the market.
 

Integrated investing

 
The second category is ‘integrated investing’, where ESG considerations balance more traditional financial analysis. One approach under this category is to consider ESG as a risk category to help provide context on the fair value of an investment.

An enterprise might be considered to carry high ESG risk if it was associated with, for example, fossil fuels or munitions. These strategies will potentially still hold investment positions with high ESG risk if the valuation is attractive enough, an approach that sometimes causes confusion with investors.

Here, it can be helpful to consider an analogy related to credit risk and high yield bonds. Most holdings in a high yield bond portfolio represent corporate bond issuers with high balance sheet leverage (a high proportion of their assets being financed by debt) and therefore high credit risk, but the portfolio manager believes the valuation is compensating investors for that risk. It is the portfolio manager’s job to apply that judgement.

Another approach to integrated investing, not mutually exclusive, is to focus on stewardship (i.e. engagement). Most forms of investing come with the opportunity to engage with the people responsible for managing the associated operations.

Equity investments provide the opportunity to vote on company resolutions, and most large equity stakes will grant direct access to a Chief Executive or Chairperson.

Access to company management provided by debt investments is often considered to be less direct, but in cases where there is a closer relationship between lender and borrower this avenue can also be important. In any case, there is an opportunity to encourage or even pressure the management team to improve their ESG performance over time.

The value of this tool should not be underestimated, as there have been several cases where investors have been able to influence significant change in corporate behaviour.
 

Impact investing

 
The last category is ‘impact investing’. It is important to recognise the scope of this category has been expanding in recent times.

It started with a somewhat purist definition associated with investment strategies that actively direct capital to organisations that are providing a clear solution to an environmental or social problem to deliver a positive ‘impact’ on society.

There can be a range of themes in play here such as renewable energy, alternative forms of propulsion, better access to medicine.

This has since expanded to include a sub-category of strategies focused on financing or encouraging change in broader economic activity – this still impacts society under certain themes, but the scope of companies in the opportunity-set is larger.

For example, an equity investor in a traditional oil and gas company may use the stewardship avenue to encourage the company to transition the business toward cleaner sources of energy.
 

ESG – the challenges

 
It would be remiss to not address some of the challenges associated with ESG investing. The first is a lack of sufficient data disclosure. Many of the metrics ideally used to track a company’s ESG performance are not disclosed consistently and, even when they are, there is often a significant time lag involved.

This means investment decision makers must either rely on estimation techniques or conversations with management to fill in gaps on the company’s ESG performance and commitment.

The second challenge is the practice of greenwashing, which means putting forward an investment as ESG-focused when really it is not. This can be very challenging for investors to assess, particularly when looking at integrated strategies that are balancing ESG risk against valuation.

The last, and potentially most important challenge, is estimating the impact ESG will have on investment performance going forward.

There is increasing evidence of a positive relationship between ESG performance and investment returns, which is clearly encouraging, but that evidence is most robust when one looks at investments within the same industry, for example beverage manufacturer versus beverage manufacturer.

But it would be inappropriate to extrapolate that evidence to a logical extreme, suggesting higher ESG credentials will always deliver a better financial result, as there are often differences in systematic (market) risk profiles to consider. We must remember that systematic risk and expected return are linked.

Despite the challenges, it is clear that ESG investing is here to stay. While it requires effort, and potentially financial advice, actively managed, as opposed to passive, portfolios are particularly well-suited to the analysis and engagement that ESG investing requires.

These funds or strategies can be selected to align with personal risk and return preferences and match up with the shade of ESG investing that is right for you.