By Matt Kelley, CFA, Portfolio Strategy Manager
& Chris Sardi, CFA, Portfolio Strategy Analyst
Recent trends and data show that many Fortune 500 companies are adopting environmental, social, and governance (ESG) practices, and investment companies are beginning to offer more opportunities to invest in ESG. The universe of funds has recently become broad enough that it’s even feasible for an investor to build an entire diversified portfolio using only ESG funds.
What are ESG Funds?
ESG investing is any sort of investment strategy that takes some or all of these factors (environmental, social, and governance) into consideration when building out your investment portfolio. ESG investing is commonly used interchangeably with socially responsible investing (SRI) and impact investing, though there are differences. SRI is a predecessor to ESG investing and generally involves strategies that exclude “immoral” companies (negative screening). Impact investing is investing for the sole purpose of making a positive impact (i.e investing in bond that is funding a company’s switch from fossil fuels to renewable energy).
The Three Pillars of ESG: Environmental, Social, and Governance
Environmental:
The first pillar relates to a firm’s impact on the environment. Criteria generally include a company’s energy usage, pollution and waste, and use of natural resources. A company’s environmental improvement initiatives are also considered as a positive metric (e.g., electric cars, using renewable energy, etc.).
Social:
The social pillar correlates to a firm’s impact on society and stakeholders in the company. Factors considered here include the safety of a firm’s products, its treatment of employees, charitable initiatives, supplier relationships, impact on local communities, and employee diversity.
Governance:
The third pillar attempts to explain the risks in a firm’s governance structure. Some popular metrics include board diversity, accounting policies, executive pay and compensation, ownership structure, and overall ethical behavior.
Additional Considerations in the ESG Framework: Controversies and Sin Stocks
While the three main pillars of ESG investments seek to affirm an organization’s positive internal and external impacts, often times, controversial events that firms are involved in will also need to be considered as part of the larger ESG framework. Generally, these are instances or situations a company is involved in that have a negative environmental, social, or governance impact. Some examples include oil spills, health allegations relating to a company’s products, workplace sexual harassment allegations, regulatory sanctions, anti-competitive behavior allegations, protests, and employee strikes, among others.
Most firms that score companies on ESG metrics incorporate controversial events as part of the research and rating process, and will give lower scores to companies that are currently involved in or have a history of involvement in serious controversies or disputes.
The term “sin stocks” refers to companies that are involved with activities deemed unethical or immoral. These usually include companies within the industries related to alcohol, gambling, tobacco, weapon manufacturing, and adult entertainment. However, the definition can include more or fewer industries, depending on the source. Many ESG funds will screen out “sin stocks” as a first step in their strategy.
The Evolution of ESG Investing
The first form of SRI investing dates back to the 1800s, when the Methodist Church urged its members to restrict investments in controversial companies, particularly alcohol, tobacco, weapons, and gambling companies.
In the ’60s, ESG became much more mainstream, around the same time as the evolution of the mutual fund industry, the civil rights movement, and the protesting and boycotting of companies involved in or in support of the Vietnam War. As time progressed, in the ’80s, ESG investing helped dismantle the apartheid in South Africa, as investment decisions of churches, universities, cities, and states during this time moved many U.S. corporations to divest themselves out of South Africa, leading to severe economic instability in the country (Nelson Mandela, Apartheid, and SRI: A Brief History Lesson).
The idea of restricting investments based on values alone is nothing new, and these types of investments still make up a large part of the ESG universe today. However, it wasn’t until recently that ESG investing evolved to include a large range of strategies and styles that span all asset classes and geographies. Present-day ESG investing essentially took hold first in Europe, where regulations and standards relating to ESG started to develop in the early 2000s.
A major obstacle for managers to implement ESG investing was the conflict of “fiduciary duty” and sustainability. Prior to 2005, it was unclear if implementing an ESG strategy went against a manager’s fiduciary duty for its clients. For example, if ESG did not add value in the traditional risk-and-return sense, it should not be considered in the investment process. After a landmark report in 2005 commissioned by the United Nations Environment Programme (UNEP), which stated that considering ESG factors does not go against fiduciary duty and could arguably be required in many aspects, a lot of doors opened for ESG to become mainstream.
The ESG universe is still emerging in the U.S., while it has matured more in Europe and other parts of the world. We can see these signs not just from record growth rates of fund flows into ESG, but from changes in corporate policies across major companies and large money managers beginning to take a stance on the issue.
Be sure to check out Part Two of the ESG Investments series: What You Need to Know Before Investing.
About Matt Kelley, CFA
Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.
About Chris Sardi, CFA
Chris Sardi is a Portfolio Strategy Analyst with ESL Federal Credit Union. In his role, Chris is responsible for managing the development and coordination of research and due diligence/guidance on investment products for internal and external portfolio construction and management for ESL.
