The concept of ESG investing -- with ESG standing for environmental, social and governance factors -- has come to the forefront in recent years as a set of metrics by which to gauge individual companies, as well as investments in mutual funds and ETFs. Does ESG investing make sense for your clients?
Investors sometimes confuse ESG and socially responsible investing (SRI). SRI typically involves screening companies to ensure they don’t engage in activities that might be offensive to groups of investors. These could include things like tobacco or gambling, for example.
The goal is to ensure that companies engage in these or other prohibited activities or lines of business are excluded from investor portfolios. SRI investing can be done by picking individual stocks, or via ETFs and mutual funds that are designed around avoiding companies engaging in certain business activities.
ESG looks for companies that score well on environmental, social and governance factors and have integrated these factors into their business. The premise is that companies that score well on adherence to these factors are likely to be well-run and not susceptible to litigation based on these issues.
Examples of environmental factors include:
- Climate change
- Greenhouse gas emissions
- Carbon footprint issues
- Renewable energy
- Pollution of water and the environment
- The company’s relationship and issues with the EPA (Environmental Protection Agency)
Examples of social factors include:
- Employee treatment, including equal and fair pay issues
- Employee safety issues
- Sexual harassment
- Consumer related issues
- Social justice issues
Examples of corporate governance factors include:
- Executive compensation issues
- Compensation as it relates to business metrics
- Board of director makeup and compensation issues
- The voting process for board issues
- Shareholder communications
- Any regulatory history with the SEC (Securities and Exchange Commission)
The difference between ESG and SRI is that investors focusing on ESG tend to flock to companies that score well on adherence to ESG factors, while SRI is more about the exclusion of companies that engage in the types of business or with products that these investors want to avoid.
Incorporating ESG into Portfolios
Including companies that score high on ESG factors can actually reduce risk. For example, a company that is continually found liable for environmental issues such as pollution or business practices that lead to pollution of the environment could be hit with fines or lawsuits based on these practices at some point in time. These types of violations can be costly to the company in terms of potential fines and can result in lost business.
Likewise with companies that are in violation in terms of social governance. An example here might be companies that mistreat workers. This could lead to legal troubles, but more so to a disgruntled workforce who is not as productive as they might be. This can lead to reduced profitability.
Companies whose management teams incorporate best practices relating to the various ESG factors into the mainstream of their enterprise tend to be well-run companies who are often very profitable.
As far as looking for investments that rank well on ESG factors, there is a growing body of research and data out there to refer to for both individual stocks, as well as for mutual funds and ETFs. The use of key performance indicators can be a tool for integrating ESG into the main fabric of a client’s portfolio. An example of a key performance indicator might be the percentage of women in senior management positions within the company.
Client investments should still be based upon an asset allocation that arises from the financial planning work that their advisers do for them, and be based upon metrics such as their age, time horizon for needing the money and their risk tolerance. ESG metrics can be considered within these frameworks.
ESG is gaining traction among both individual investors and institutional investors. This means that your clients of either type may well have an interest in incorporating ESG screening into their investment process.
As an adviser you can help those clients interested in ESG investing implement this as part of their portfolio, while keeping them focused on key investing goals like asset allocation and risk control.