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A Q&A on ESG Investing

Posted by Gerard Michael on Aug 19, 2021

 

 

We answer common questions on ESG investing. 


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Below is a Q&A based on questions we get about ESG investing. You can also watch an ESG webinar hosted by our parent company, Smartleaf, Inc.

 

Q: What is ESG investing?

A: ESG stands for “environment, social and governance,” and “ESG investing” means that environmental, social and governance criteria enter into your investment decisions, supplementing more traditional factors like earnings, growth, etc. There are four main ways ESG considerations can be incorporated into investing:

  1. ESG Screening
    ESG screening (also called “ESG negative screening”) seeks to eliminate companies with poor ESG records from an investor’s portfolio. The canonical example is “remove tobacco stocks.”

  2. ESG Positive Tilting
    ESG positive titling means that you tilt the weight of your portfolios towards firms that have positive ESG records. ESG positive tilting and ESG negative screening are often combined.

  3. ESG Impact Investing
    ESG impact investing seeks to preferentially invest in companies whose businesses will have a positive impact on the world in a specific way. For those interested in the environment, an example might be investing in a wind-powered electric generation company. The idea is to make money, but do good at the same time. ESG impact investing is more restrictive than ESG positive tilting, which can include best-in-class companies in sectors, such as environmentally aware chemical manufacturing, that are not necessarily trying to change the world.

  4. ESG Activism
    ESG activism investing seeks to leverage one’s status as a shareholder to pressure companies to change — to make both bad companies and good companies better than they were before. In contrast to the previous approaches, ESG activism can lead to investing in companies with poor ESG records, precisely because they may be the companies with the most room for improvement.

 

Q: Does ESG investing affect returns?

A: Hard to say. The point of ESG investing is not positive investment outcomes, per se. It’s possible that companies with positive ESG attributes will outperform, but if that’s the motivation for applying ESG principles, it’s not really ESG investing — it’s just an investment strategy.

Over the last few years, ESG investments have done well. However, this seems unlikely to be permanent (on the theory that if ESG investing was obviously better, non-ESG investors would buy enough ESG companies to drive prices up, thereby eliminating any forward-looking advantage).

 

Q: How common is ESG investing?

A: Globally, 26% of professionally managed assets have ESG parameters, with about 21% in the US and over 50% in Europe. So ESG investing is not a fringe concept. 

At present, these assets are mostly owned by institutional investors, not individuals, but we can attest from our own experience that the importance of ESG investing is increasing among advisors serving individual investors. This is partly because the percentage of investors who are interested in ESG is growing. It’s also because when investors do ask for ESG constraints, it is often a make-or-break issue: the investor will walk away if the advisor cannot accommodate their wishes.

 

Q: What’s the primary motivation for ESG investing? 

A: With negative screening, positive tilts and impact investing there is a fairly straightforward rationale — investors prefer to own less of firms they disapprove of (say, a tobacco company) and more of firms they do (say, a solar energy company). And this preference can hold regardless of whether their ownership choices change things, either by improving the conduct of companies they see as bad companies or helping companies they see as good. (Though, with smaller companies, especially startups, impact investing may, in fact, make a difference).

In contrast, with ESG activism the motivation to make a difference is front and center.

Some ESG investors may be motivated by a belief that companies with good ESG track records will outperform their peers, but, as we’ve noted, right or wrong, this just makes ESG a type of investment strategy, rather than an independent reason for stock selection.

 

Q: Does ESG investing change company behavior?

A: It’s hard to say. ESG-focused shareholder activism obviously has the potential to change company behavior if the number of ESG-minded shareholders is large enough. And it doesn’t always require a majority to make a difference. Given that institutional investors own lots of shares and a large percentage exercise ESG principles, getting a hard-to-ignore group of shareholders to support ESG initiatives is not out of the question.

With ESG negative screening, positive tilt investing and impact investing the causal chain is less clear. The main problem is that you would expect non-ESG investors to balance things out. If, for example, the boycott of tobacco stocks by ESG investors actually managed to bring tobacco stock prices down, tobacco stock yields would presumably go up and non-ESG investors would have an incentive to buy more, canceling out the effect of the ESG screening. If the investment is in private capital or an IPO (in which case the money goes directly to the company you’re trying to help), it’s more plausible that the investment is helping the company. 

One interesting indicator that ESG investing does make a difference is that executives at negatively screened companies argue against being excluded and executives at positively screened companies tout their ESG bona fides. So it would appear the affected companies themselves believe it’s important.

 

Q: How do you implement ESG investing?

A: There are two basic answers:

  1. Buy ESG products — ETFs, mutual funds, separately managed accounts (SMAs), or SMA models with a green tilt. There are a lot of choices, and the list is growing. All ESG products will employ some combination of negative screens and positive tilts. Most will vote shareholder proxies with an ESG focus. Some will engage in shareholder activism.

  2. Apply negative screens and tilts to your existing portfolio. You can outsource this or do it with software.

 

Q: How does ESG investing fit in with “normal investing”:

A: ESG investing considerations are an addition to standard investing criteria, not a substitute. That is, ESG investors still care about a company’s growth prospects, earnings variability, creditworthiness, etc. But they also care about environmental, social and governance issues that fall outside of traditional investing metrics.

 

Q: Where is ESG investing headed?

A: ESG investing used to be something of an afterthought for wealth managers — a niche offering. No more. This is partly generational — younger investors care more about ESG. But it’s also part of a larger trend among advisory firms to turn away from product-oriented and performance-oriented value propositions. In its place, firms are emphasizing helping clients meet their goals — whether financial or ESG related. Instead of ESG investing and “normal” investing being compartmentalized, we’re seeing ESG investing becoming part of the norm.

 

 

SAM and ESG investing. SAM supports multiple ESG screens (Catholic Values, Sharia Values, environmental record, etc.) and offers multiple ESG equity strategies, both from SAM and from third-party ESG-specialist asset managers. We expect to add support for ESG tilts in 2022.

Gerard Michael
Gerard Michael

President, Co-Founder