You don’t have to compromise your ethics, or returns, to invest
Investing is becoming less about just making money and more about making a difference. This is a global trend. As more and more investors see that their money can be put to use not just for their own benefit but for the benefit of society generally increasingly large amounts are being allocated to investments which can help to achieve these noble goals. This type of investment approach is called Socially Responsible Investing or, more commonly, ESG. ESG stands for Environmental, Social and Governance and its three parts are the broad categories which are considered important to guide investments which are driven by the desire to make a difference to the world.
Let’s take a look at these three components more closely.
Environmental components take into account a company’s energy use, waste, pollution, natural resource conservation and how they treat animals. An evaluation of any environmental risks — and how the company is managing those risks — will also be undertaken to ensure that the company has no financial exposures from mismanagement of the environment. A company might face environmental risks related to land or water contamination, its handling of hazardous waste or emissions, or its compliance with a government’s environmental regulations.
Social criteria look at the company’s business relationships and its relationships with the communities in which it operates. Social considerations look at the alignment of values between a company and its suppliers, or whether the company helps the local community, especially in third world locations. A company’s regard for its employees’ occupational health and safety, child and slave labour, and standards of employee engagement in the supply chain are considered. These are major factors for organisations operating in less-developed countries where worker exploitation can be commonplace. The manufacture of controversial weapons also falls in this category.
Of vital importance are the Governance structures in place within the organisation. Investors need assurance that a company uses commonly-accepted accounting methods, and they want to be sure that they can have their say on important issues through transparent proxy voting procedures and that the independence of the board of directors is not compromised. Investors prefer not to invest in companies that engage in corrupt conduct to obtain favourable treatment from regulators of government.
Two ways to achieve an ethical portfolio
To produce an ESG investment portfolio a manager can take one of two approaches to include the most appropriate investments to cater for investor preferences. The first is called a negative screen and it’s possibly the most intuitive approach. With a negative screen you go through the list of potential companies in which to invest and strike out the ones that don’t comply with your moral or ethical stance. Some obvious companies spring to mind: tobacco manufacturers and the makers of what are called “controversial weapons” which include chemical and biological weapons, land mines and cluster munitions. Many ESG strategies simply exclude these companies (there are about 6 developed-market tobacco companies and a dozen or so weapons firms) with no effect on overall portfolio construction. Other industries that might be considered for exclusion are nuclear power plants, coal mines, coal-fired power stations, steel mills and other greenhouse gas-intensive manufacturers. Organisations operating “sweat shop” operations in less-developed countries may also be excluded.
If outright exclusion of companies isn’t deemed warranted then a positive screen may be used. This is where the “least worst” companies in an industry group are not excluded since they are considered to be better than their peers when rated on one or more ESG criteria. In this way entire industry groups are not left out of a portfolio and investments made in only those firms considered to be using best practices.
There’s often no “one size fits all” approach to ESG investing as agreement on what should be excluded can often not be reached. While most investors would probably concur that tobacco and controversial weapons have no proper, safe use so should be left out other potentially contentious investments may be more open for debate. Examples include gambling stocks, alcohol companies, contraceptive manufacturers and those which don’t comply with various religious requirements. As a result, fund managers find it hard to create a product that will suit enough investors to create a fund of sufficient size to be economical to run. ESG selection is often left to individual investors who can cater for their own ethical and moral situations.
ESG fund performance
It’s fair to ask whether the moral high ground has a cost as measured by returns. According to the Responsible Investment Association Australasia’s Responsible Investment Benchmark Report 2017, ESG-type funds for Australian Equities, International Equities and Multi-sector Funds have all outperformed their non-ESG counterparts on ten year time scales. That’s a very good track record for these types of funds. Of course this is an aggregate measure and any particular fund may not experience the same outcome.
So if your investment goals include making a difference for yourself but also for the world you might want to consider some ESG investments in your portfolio. A financial adviser can point you in the right direction and discuss the relevant pros and cons of individual funds for your needs.
What is clear is that you don’t have to sacrifice the world, or investment performance, to create a better future for yourself.