Recycling for Earth Day: Q&A on ESG
In the spirit of Earth Day, we are recycling a previous Q&A post on ESG investing. We cover everything from the basics of “what is ESG investing” to how ESG investing gets folded into standard investing practice. (See also: Doing Well by Doing Good?, a conversation on ESG investing with Pearl Impact Capital.)
Q: What is ESG investing?
A: ESG stands for “environment, social and governance.” There are three types:
- ESG Screening
ESG screening (more precisely, 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.”
- ESG Impact Investing
ESG impact investing (also called 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 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 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.
Q: Does ESG investing affect returns?
A: I think it’s worth noting that 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. Roughly speaking, it seems to be the same as non-ESG investing based on a simple model of how the market works. 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.
Q: How common is ESG investing?
A: In the US, one third of professionally managed assets have ESG parameters. So it’s not a fringe concept.1
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? Does it change company behavior?
A: For most people, there is a fairly straightforward moral imperative with ESG — 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), whether there will be an impact on company behavior is muddled. 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 presumptively 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 in the other direction 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.
Q: How do you implement ESG investing?
A: There are two basic answers:
- 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.2
- Use automated rebalancing software, like ours, to apply ESG screens. (You can also do it yourself manually using screening tools, but that’s not practical at scale.)
Q: How does ESG investing fit in with “normal” investing?
A: At an abstract level, the quick —albeit slightly vague— answer is that there needs to be a balance between ESG preferences and standard investment criteria. If ESG constraints reduce your buy list to two stocks, you’ve got a problem, but some additional risk is OK. 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 would be easy enough to apply this to ESG investing, as well. But we’ve never seen a firm actually implement this as a policy. This may be because most advisors lack the tools to appropriately measure the risk impact of ESG investing, which puts them in a tough spot. Fortunately, this is easily fixed. The technology exists to provide advisors with real-time feedback on the risk consequences of any ESG decision (and, yes, we’re building this out in our own system).
Q: Where do you think ESG investing is headed?
A: I can talk a little bit about our own experience working with advisory firms buying rebalancing technology. ESG screening functionality used to be something of an afterthought. No more. ESG is now a short-list concern for virtually every firm we speak with. In part, 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.
Q: A final question: where does Smatleaf fit in?
A: We’re all in. Support for ESG investing was central to Smartleaf founding vision. Automated implementation of ESG constraints has been part of the Smartelaf system since our first production release in 2003. Our model hub, the Smartleaf Model Distribution service (MDS) contains multiple ESG models. And there is more to come. Through our RIA subsidiary, Smartleaf Asset Management (SAM), we are adding support for green direct index models, and we will be releasing support for automated implementation of ESG tilts.