By Chris Chen, CFP®, CDFA®
This article was written by Chris Chen and Eric Weigel
The term socially responsible investing (SRI) is often used interchangeably with sustainable investing. In general, the term describes an approach to investing that combines traditional financial methods to portfolio construction with the desire to simultaneously create positive societal outcomes.
The investment management industry has now adopted the term environmental, social and governance (ESG) metrics to describe non-financial corporate behavior. (For related reading, see: Big Money Is Moving to Socially Responsible Investing.)
History of Investing to Create Positive Social Change
In its early days SRI approaches took an exclusionary view to investing. For example, tobacco companies were often excluded from portfolio mandates. Another, probably more extreme example involved the divestment of South African investments during the apartheid era. Companies typically (un)selected under this form of exclusionary screening had to meet a minimum threshold of “do no harm.”
More recently, investors have looked at ways to create positive social outcomes within their financial portfolios. While still excluding companies deemed to exhibit poor ESG practices, the focus has shifted toward emphasizing investments with a dual objective of superior risk adjusted financial returns along with demonstrably positive environmental, societal and/or governance outcomes.
The idea of “doing well while doing good” is the basic rationale why investors are increasingly interested in enhancing how they manage their portfolios by including non-financial metrics such as environmental, societal and governance factors.
Why Investors Are Motivated By SRI Strategies
Besides ethical and moral motivations, why have investors suddenly become so interested in SRI approaches to investment management? Simple - self interest combined with the realization that currently disclosed financial metrics are insufficient to properly account for the long-term sustainability and valuation of companies.
Investors large and small have woken to the fact that environmental issues, such as climate change and carbon emissions, have significant implications for our global well being as well as for the long-term financial health of companies. This is the E in ESG.
Investors are also becoming very interested in the societal impacts of corporate behavior - issues such as workers’ rights, gender and diversity policies and human rights in general. This represents the S in ESG. For example, recent sexual harassment scandals at FOX News highlight the impact of non-financial events on corporate valuation. (For related reading, see: Ethical Investing: Socially Responsible Investing.)
Probably the oldest way of using non-financial criteria to evaluate companies involves the area of corporate governance. This is the G in ESG. Board composition, executive compensation practices and sustainability disclosure criteria are just three areas of increasing investor attention.
Research indicates that the idea of “doing well while doing good” is achievable if properly implemented. One of the concerns of early investors in SRI approaches was that excluding companies deemed to be “bad actors” would significantly restrict one’s investment opportunities and returns would commensurately suffer.
This argument has been made by financial theorists but recent empirical studies show that returns need not suffer especially when risk adjusted. Part of the issue obfuscating the matter is that many of the early studies focused on a very wide spectrum of ESG issues.
What Is the Material Impact of ESG and SRI?
Recent research has focused on ESG issues deemed to be material. What is material you might ask? Generally, materiality revolves around the concept of usefulness to a rational investor in making financial decisions. Many ESG issues are important from an ethical perspective but have limited influence on the long-term fundamental health of a company.
Research by Harvard professors Khan, Sarafeim and Yoon identified a large variation in long-term measures of company financial success when evaluating companies on material ESG metrics. Their conclusion is that companies with superior sustainability practices outperform companies with poor practices.
While much of the research on using SRI/ESG investment approaches is in its infancy, our take is that properly constructed portfolios incorporating financial as well as non-financial ESG criteria are competitive on a risk-adjusted basis over short holding periods while providing significant positive upside over the long-term. Our belief is that investors enhancing their approach to portfolio construction by incorporating ESG criteria will benefit long-term from lower levels of business risk in their holdings as well as potentially higher stock returns.
Companies with superior ESG practices tend to provide greater transparency in their disclosures, be better prepared to deal with adverse events when they happen and be more open to adapting their business models around environmental, social and governance issues likely to be material over the long-term.
The same risk-return balancing issues that apply to any investment portfolio apply to an approach using SRI/ESG criteria. The biggest difference at the moment occurs at the implementation stage.
The implementation of SRI/ESG portfolios requires some additional research and caution. While a growing universe of investment vehicles exist in the form of mutual funds and exchange-traded funds, there are wide differences in liquidity, composition and cost. Properly conducting due diligence on the various SRI/ESG offerings requires an above average level of financial research sophistication and experience. (For related reading, see: 3 Trends to Watch in ESG Investing.)
This article was originally published on Investopedia.