Investments, Strategy

ESG investment decision-making

Global environmental, social and governance (ESG) assets under management grew by an estimated 73 per cent globally over the space of four years to December 2016.

The reasons for this growth are multifaceted, however, there are two main drivers: better availability of ESG-related data, and global responsible investing initiatives and regulatory developments.

With this growing interest in ESG investing, which in turn is driving growth in product choice, it’s worth understanding the options available for ESG investors to find a strategy that best aligns to their goals in this form of investing.

Defining goals

Approaches to ESG investing can vary widely depending on investors’ age and background.

For example, the CFA Institute’s research suggests women are more interested in ESG issues than men, and millennials are more interested than baby boomers.

Some investors are taking a purely financial approach by targeting companies with favourable ESG practices to enhance returns or reduce risks.

Other investors are making a values-based judgment to exclude exposures to industries such as tobacco, alcohol, gambling or munitions.

Understanding the options

Portfolio screening can take two main forms: exclusionary screening, which removes stocks or sectors the investor wants to avoid, or inclusionary screening, which uses inputs from either the investment manager or a third-party provider to up-weight ‘good actors’ and down-weight ‘bad actors’ according to the criteria set by the investment manager.

Many investors are driven by a values-based judgment to divest from companies whose activities they disagree with.

The list of potential ESG issues is extensive and growing, and a question that often arises is what companies, in what part of the supply chain, count. While some investors prefer a zero tolerance, others prefer to put in place a threshold in relation to what proportion of revenue a company derives from the undesirable activity.

One of the big ESG debates is whether it’s better for asset owners to ‘vote with their feet’ or ‘vote with their vote’. Advocacy can be an effective way of maximising financial returns without compromising diversification.

Advocacy seeks to influence positive change through the power of voting rights and engagement with companies, rather than removing yourself from the conversation by divesting.

ESG integration incorporates risk exposure into the investment process. A company may be subject to a high degree of ESG risk, but if the price reflects that, then it may still form part of an investment portfolio. Many super and managed funds follow a similar approach.

Impact investing involves allocating capital to generate both a positive social or environmental impact and a financial return. Also referred to as triple-bottom-line investing, it remains a small component of the ESG universe and carries more complexity in the form of niche funds accessed through private investment vehicles.

Being aware of what the options are, investors can choose a portfolio solution that best aligns with their ESG goals and the available options.

Choose a strategy and regularly assess it

The next step is for investors to choose an investment based on what criteria they’ve determined are most important to them, ensuring their expectations are clear once a decision on what action to take is made.

Similar to investing in funds focused on growth or value stocks, investors in screened ESG products can expect periods of outperformance and underperformance relative to a broad market benchmark.

For advisers, practice management considerations may be important to include in the decision-making process, for example, how to respond to client or prospective client inquiries if a decision is made to not offer screened ESG investment options for individuals with strong moral preferences.

Individual investors can use a well-structured set of criteria to help ensure they are considering the potential direct and indirect consequences of any actions.

The ESG investment landscape is far from static. Not only are investor preferences changing, but investment options are rapidly evolving, supported by a growing recognition that it’s possible to do well while doing good.

Like any other investment choice, however, a systematic approach to assessing your strategy can keep your goals in close alignment with your investment portfolio.

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