You may have heard the term “ESG Investing” in the news, from a friend, or through your church. What exactly is ESG investing, and might it be right for you?
ESG is an evaluation of a company’s conscientiousness for different factors that are intangible and therefore are not compiled within its financial statements.
The E in ESG Investing stands for Environmental. This factor looks at how environmentally responsible a particular company is. Chief areas of concern within this factor look at the climate issues (mainly greenhouse gas emissions) and sustainability (waste management, resource management, and water management). Investment managers compile data related to these areas and screen companies out of the investment universe if specific criteria aren’t met. A screen might be to remove traditional energy companies involved in the production and refinement of fossil fuels.
The S in ESG Investing stands for Social. This second factor looks at how socially conscience a particular company is. Areas of concern within the social factor may consider employee diversity, human rights (child labor), consumer protection, and animal welfare. Other areas often excluded are alcohol, gambling, tobacco, and weapons. For example, if a company derives more than 15-20% of its annual revenue from these categories, it may be excluded.
The G in ESG Investing stands for Governance. This factor considers the corporate governance of the company, its board, shareholders, and other stakeholders. For example, the balance of power between the chairman of the board and the CEO or other areas such as employee relations, executive compensation, and employee compensation may be considered. While the “G” may seem a bit more abstract or even dull, proper alignment of incentives for executives and a well-functioning board representing the interest of shareholders is essential, as it may improve your long-term returns.
How to Be ESG
So how do you get started with ESG Investing? Over the past decade, the amount of data and investment offerings surrounding ESG Investing has proliferated. Large data providers such as Bloomberg, MSCI, S&P, Moody’s, and Morningstar provide ESG screens. Many mutual funds and ETF providers have expanded into the ESG space. They either use ESG metrics as part of their underlying investment analysis or solely use ESG screens to build their portfolios. These “off the shelf” options may be well suited for you to get started.
Another and the most customizable solution to ESG investing is using a separately managed account (SMA). An SMA allows a third-party investment manager to buy and sell individual securities within your investment account. This differs from a mutual fund or ETF in that you have full control over the investment criteria used. You may utilize differing ESG screens based upon your personal values and do not have to rely on “off the shelf” products that might not align exactly with your values. Due to technological advancements, costs for SMAs and required minimum investments have decreased substantially in the last few years. In fact, SMA costs can be quite similar to off-the-shelf solutions provided by mutual funds and ETFs.
An executive at Goodyear and their spouse wanted to align their investments to their faith, based on the socially responsible guidelines from United States Conference of Catholic Bishops (USCCB). Further, the executive was an Insider under SEC rules and needed to screen out purchases and sales of Goodyear stock. Lastly, they also had some stock holdings that would be costly tax-wise to sell and needed to be incorporated into their overall portfolio in a tax-smart manner. In this case, a low-cost SMA with customization and tax benefits coupled with the desired screenings was the clear choice to meet their goals.
ESG investing isn’t cut and dry. While some screens are quantitative in nature many are more qualitative. Thus it’s often difficult to determine where to draw the line and screen out a company. One common screening service excluding companies that have had “major, recent controversies relating to child labor infractions.” What is major? What is recent? And who is determining this?
Historically, ESG investing came at a high cost. Products were expensive and results tended to be poor. So there was a relative loss you likely experienced compared to not pursuing ESG investing. Yet, today, solutions are much more consumer friendly but still require proper implementation.
While almost nothing is perfect, if aligning your investments to be more congruent with your values is important to you, then ESG investing – whether through a good off-the-shelf solution or through a more customized one – may be right for you.