As mentioned in previous blog posts, environmental, social, and governance (ESG) criteria are standards for a company’s operations that socially conscious investors use to screen potential investments.1 In essence, it is the moral compass people use when deciding on what companies they plan to invest in. While ESG investing is growing in popularity in the United States (and the rest of the world), there is not a single definition of what it means in practice.2 This type of investment screening is also known as socially responsible investing (SRI) or “socially‐ conscious” investing.3 It is also called sustainable investing, mission investing, or impact investing.4 For ease of reference, we will refer to this investment methodology simply as ESG investing. ESG can be further broken down as follows:
Environmental criteria assess how good a steward of nature an organization is. It also can be used to evaluate any environmental risks that a company may be facing and how well that company is managing those risks.5
Social criteria examine how a company manages its relationships with employees, suppliers, customers, and the communities where it operates. In other words, how closely does it monitor the suppliers that it works with? Do these suppliers have the same values? What kind of social impact does the company have on the local community where it operates?
Does it encourage employees to volunteer to help these communities? Does the company employ adequate health and safety measures to protect its employees?6
Governance reflects how an organization governs its leadership, executive pay, audits, internal controls, and shareholder rights. Are these in line with what the company says that it stands for? Do they use accurate and transparent accounting methods? Can shareholders vote on important issues? Do they avoid conflict of interest when selecting its board members? Do they engage in any illegal practices or use political contributions to gain favorable treatment from lawmakers?7
Another way to look at ESG investing is that it can help investors invest in companies with values that match their own. While there is no legal or regulatory definition of ESG investing, it is generally understood to have the goal of long‐term performance and risk management while promoting positive outcomes outside financial returns alone.8
The modern ESG investing movement dates back to the 1960s and started in the U.S. as a response to larger social movements like the anti‐war, environmental, and social welfare movements prevalent at the time. Investors that supported these causes actively sought opportunities to invest in equity and debt markets that better aligned with their personal beliefs.9 Initially, early ESG investing employed the use of negative screens to exclude the types of investments that certain investors found personally objectionable, like the proverbial “sin stocks” of alcohol, tobacco, gambling, adult entertainment, and weapons of war. But, over time, ESG investing has developed more complex strategies that use sophisticated ratings in an effort to invest in issuers believed to contribute positive impacts on the world.10 As Janus Henderson Investors stated:
“It is our fundamental belief that ESG considerations enhance risk‐adjusted return potential by reducing investment risk and creating investment value. A well‐run and responsible company that cares about its people, customers, and the environment, we believe, is more likely to exhibit a greater level of resilience and outperform its peers than one that does not. ESG analysis can provide valuable insights about factors that can have a significant impact on the financial metrics of a company and therefore better inform our investment decisions. It is not just a case of evaluating the products and services provided by a company, but also its behavior, conduct, supply chain, and other considerations in running the business. ESG analysis must also consider the future, taking into account not only a company’s latest ESG disclosures, but also its strategy, overall impact, and evidence that it is keeping to its commitments and standards. Hence, we believe it is not advisable to formulate investment decisions based on purely backward‐looking historical data and believe a more forward‐looking, dynamic approach is needed when considering ESG risks and opportunities. While exclusion‐based strategies adopt a negative approach to investing, our holistic approach takes a more positive stance and also looks for opportunities where companies are actively transitioning and improving their ESG profiles. The combination of improving credit stories and improvement on ESG grounds can help achieve positive outcomes for the environment and society.”11
This positive screening method can help investors identify companies with more robust ESG track records and/or policies and practices that they support. While less common, impacting investing directly targets specific environmental or social problems to achieve measurable outcomes.12 There are also various integrative approaches combining robust ESG data with traditional financial analysis that tend to be more proactive and comprehensive, so they are less likely to avoid entire industries. Instead, industry peers are compared to determine which companies have taken more significant steps toward meeting environmental and social challenges, potentially gaining a competitive advantage.13
I hope you enjoyed the fourth post in a seven-week series on Environmental, Social, and Governance (ESG) investing. Check out other posts in the series here:
An Introduction To ESG Investing
The Theory Of Sustainable Investing
What Is The Triple Bottom Line?
The Popularity of ESG Investing
(1, 4-7) Chen, J. (2021, March 5). "Environmental, Social, and Governance (ESG) Criteria". Retrieved from Investopedia: https://www.investopedia.com/terms/e/environmental‐social‐and‐governance‐ esg‐criteria.asp.
(2, 8-10) Bourgeois, J., Massey, J., & Perlow, M. (2019, December). "ESG Investing: Considerations for U.S. Registered Investment Advisers". Retrieved from The Investment Lawyer, Volume 26, No. 12, p. 18‐25.
(3) Chen, J. (2021, April 2). "What is a Socially Responsible Investment?". Retrieved from Investopedia: https://www.investopedia.com/terms/s/sri.asp.
(11) Janus Henderson Investors. (2019, November). "What is ESG and Why Do We Care?". Retrieved from https://www.janushenderson.com/en‐us/investor/article/esg‐and‐why‐care/.
(12, 13) Broadridge Investor Communication Solutions, Inc. (Accessed 2021, April 23). "Growing Interest in Socially Responsible Investing". Retrieved from https://www.broadridgeadvisor.com/kt/HtmlNL.aspx?pvw=A9FDFD0F708BBE2F96665A46E3B8F 96BC712956751ACE7A5BACA6AB6F4AA678EA2B%E2%80%A6.
The views expressed within this newsletter are subject to change at any time without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security or strategy. This material has been distributed for informational purposes only. All investments carry certain risk and there is no assurance that an investment will provide positive performance over any period of time. Because ESG criteria excludes some investments, ESG strategies may not be able to take advantage of the same opportunities or market trends as those that do not use such criteria. John Chichester is an Investment Advisor Representative with Dynamic Wealth Advisors dba Chichester Financial Group LLC. All investment advisory services are offered through Dynamic Wealth Advisors.