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Environmental, Social, Governance (ESG)

What is ESG investing?

ESG stands for “Environmental, Social and Governance”. ESG investing describes an approach to investing that seeks to advance ESG concerns. Religious value investing – e.g. investing in a manner consistent with “Catholic Values” or “Islamic Values” – is technically different from ESG investing, but is similar in that it introduces non-financial considerations into investing decisions. For this discussion, we’ll lump them together. There are three types of ESG Investing: ESG Screening, ESG Impact Investing, and ESG Activism.

Let’s look at these one at a time: 

  1. ESG Screening
    ESG screening (more precisely, ESG negative screening) seeks to eliminate companies with poor ESG records from an investor’s portfolio. The canonical example is “I don’t want to own tobacco stocks.”
  2. ESG Impact Investing
    ESG impact investing (also called ESG positive screening) seeks to preferentially invest in companies whose businesses will have a positive impact on the world in a specific way. For those interested in environmental and sustainability matters, 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.
  3. 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. ESG activism is the only form of ESG investing that may involve buying the stock of companies with the worst ESG records to attempt to influence improvement. 
Does ESG investing affect returns?

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.

That being said, the record on whether ESG investing is good or bad for returns is unclear. Based on a simple model of how the market works, there’s reason to think there’s no difference. If ESG investing was notably better, non-ESG investors would buy enough ESG companies to drive prices up, thereby eliminating any forward-looking advantage. If ESG investing were notably worse, you’d see this work in reverse, with non-ESG investors selling ESG companies to drive prices down, thereby eliminating any forward-looking disadvantage.

How common is ESG investing?

In the United States, something like twelve percent of professionally managed assets have ESG parameters. So it’s 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.

Is ESG overhyped?

In a way, yes. There’s a fair amount of “greenwashing” going on, where mutual funds and SMAs apply an ESG label to themselves without actually changing their investing approach. This generates confusion, but the demand for ESG investing is still real. After all, firms wouldn’t bother to greenwash if they didn’t think they were responding to a real market trend.

What's the primary motivation for ESG investing? Does it change company behavior?

For most people, there is a fairly straightforward moral imperative for embracing ESG investing — they view it as immoral to be a part-owner of, say, a tobacco company. And this preference holds regardless of whether their non-ownership changes the behavior of any tobacco company. 

But does ESG investing actually change company behavior? Does it change the outside world in any way?

The record is mixed. 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.

But with social impact investing and social screening (tilting portfolios towards or against certain types of companies), determining whether there will be an impact on company behavior is difficult. At a theoretical level, 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. 

A similar argument applies in reverse for positive tilt investing when the purchases are made in the open market. If you force the price up, the yield would go down and non-ESG investors would have an incentive to sell. 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 argument that social impact and negative screen 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 apparently they believe it's important. 

How do you implement ESG investing?

There are two ways: 

  • 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.
  • Use automated rebalancing software, like ours, to apply ESG screens or positive tilts. (You can also do it yourself manually using screening tools, but that’s not practical at scale.)
Does ESG investing raise the risk of portfolios, and is that a problem? How does ESG investing fit in with "normal" investing criteria like diversification?

The short answer is, yes, ESG investing likely increases portfolio risk. This is true of any strategy that either eliminates securities from consideration (like ESG screening) or concentrates holdings (like ESG impact investing). This is not intrinsically a problem, but there needs to be a balance between ESG preferences and standard investment criteria. Some additional risk is OK, but if ESG constraints reduce your buy list to two stocks, you’ve got a problem. 

No one would think twice about investors who wanted to use some of their wealth to fund a charitable cause. Why shouldn’t incurring a bit more risk to apply ESG investing principles be just as normal?

That being said, there are no commonly accepted principles for deciding what level of negative investment impact is too much. In spirit, firms could control the negative risk effects of ESG investing the same way they control risk when they’re overweighting securities with higher expected returns. Typically, this is done by setting diversification guidelines and/or setting limits on maximum expected tracking error relative to some benchmark. It is easy enough to apply this to ESG investing as well. Technology, such as Smartleaf’s, provides advisors with real-time feedback on the risk consequences of any ESG decision.

Where do we think ESG investing is headed?

ESG screening functionality used to be something of an afterthought. Not anymore. ESG is now a short-list concern for virtually every firm we speak with. We think this is 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.

How does Smartleaf support ESG?

Support for ESG investing was central to Smartleaf’s founding vision. Automated implementation of ESG constraints has been part of the Smartelaf system since our first production release in 2003, and our model hub, the Smartleaf Model Distribution service (MDS), contains multiple ESG models. And our Advisor Portal provides advisors and their clients with real-time feedback on the tax and risk impact of their ESG choices, so they can make more informed decisions.

Additional Resources