Artemis has recently introduced sustainable investing as an option for interested clients. Below is a brief review of the concept, a discussion of some recent trends, and an explanation about how we are approaching the opportunity.
Sustainable investing is not new.[1] Indeed, many individual clients and institutions have long expressed their values in one way or another via their investment decisions. Traditionally, this has taken the form of eliminating any investment in specific sectors (e.g., gambling, stem-cell research) or specific companies deemed to be inconsistent with one’s values.
The problem with this approach is twofold. First, what’s against one person’s values (e.g., contraceptives) may well be a godsend to another, so adopting an “exclusionary” type approach has required some amount of customization, which makes it expensive to implement. Second, research indicates that investors who have reflected their values in their investment choices by excluding certain industries often pay a price in terms of investment performance.
A good example of this is Norway’s $870 billion Government Pension Fund, which has long had a socially responsible mandate. The fund excludes two types of companies from its investment portfolio: “product-based” exclusions include weapons, thermal coal and tobacco producers and suppliers; and “conduct-based” exclusions include companies with a track record of human rights violations, severe environmental damage and corruption. According to a newly released study by the fund’s managers this year, the fund has missed out on 1.1 percentage points of gain annually on average over the last 11 years. Other studies have found similar or mixed results (at best) for similar exclusionary-type approaches.
More recently, sustainable investing has moved beyond a purely exclusionary approach to one that is more inclusionary; i.e., one that considers environmental, social and governance (ESG) criteria in addition to traditional financial metrics, but does not necessarily screen out entire industries. With this approach, investors seek companies that are deemed to perform better than their peers on the subset of ESG criteria that apply to their industry. As such, ESG screens only exclude (or minimize) those companies within an industry that score poorly on ESG criteria.
Figure 1. Environmental, Social and Governance Criteria
Source: Morningstar
The premise with this more inclusionary approach is that directing capital toward companies that are dealing effectively with sustainability and governance issues will enhance the transition to a more sustainable global economy and lead to better investment performance. The latter is posited because those companies that are effectively addressing ESG issues have been shown to perform better on a whole variety of financial metrics.[2]
Even so, many challenges remain. While there are several new ratings schemes to help investment managers and financial advisors understand which companies rate highly on ESG criteria, much less is known about how to identify the relatively small subset of the ESG data that is truly material and value-relevant for each industry. Another challenge is the still relatively low quality of the underlying ESG data being reported by companies. No consistent standard or reporting methods exist as of yet and, as a result, it is still difficult for investors and the rating agencies to compare companies across ESG metrics.
So the question becomes, do you wait to invest using ESG criteria until the data and rating methodologies are as good as traditional financial data? My view has evolved on this point, in part due to the recent introduction of wider variety of low-cost indexed-based mutual funds and ETFs (Exchange Traded Funds) that do a fairly good job of tracking traditional market benchmarks. They do so by keeping sector weights close to benchmark weights while still emphasizing companies with high ESG scores and minimizing those with lower scores. These newer products enable us to fairly easily substitute our conventional equity fund choices for ESG funds without having to change or compromise the overarching asset allocation strategy.[3]
My view has also evolved because I am increasingly finding it very intuitively appealing to send a signal to companies that issues such as energy efficiency, carbon emissions, workplace safety, and employee relations matter to investors and that investors are willing to reward those who implement good or best practices. (For example, the delete Uber movement is having an impact.) In time, the hope is that investor interest will lead to more and better reporting standards, more precise ESG ratings, and a more sustainable and just world.
The choice to introduce ESG criteria into the investment decision is an individual one. Artemis will continue to utilize conventional index-based funds in the absence of a proactive request from a client. Indeed, after 8+ years of a bull market, the capital gains costs of switching to a fully allocated ESG portfolio would be prohibitive for many current clients in any event. Please get in touch if you would like to learn more.
[1] Sustainable investing is also referred to as socially-responsive investing (SRI), environmental, social and governance investing (ESG), green investing and impact investing. Each term has come to mean something a little different in the literature. Here we using the term sustainable investing as an umbrella term for all approaches.
[2] One of the more comprehensive reviews examined more than 100 academic studies of sustainability investing around the world and found that ESG factors are strongly correlated with superior risk-adjusted returns at a securities level. The study also confirmed that corporations with high ratings for ESG factors have a lower cost of capital in terms of debt and equity and most exhibit market-based outperformance. See Deutsche Bank Climate Change Advisors, Sustainable Investing: Establish Long-term Value and Performance, June 2012.
[3] Note that this approach precludes the ability to screen out entire industries such as gambling, tobacco, etc. In addition, the available ESG fund choices for fixed income are still extremely limited precluding applying ESG criteria to the fixed income portion of the portfolio. If either of the above considerations are paramount, one would need to hire an advisor that builds highly customized individual stock and bond portfolios. Such advisors do exist but typically have fairly high minimums due to the work involved.
