There are people, some of them financial advisors, who believe that you cannot make money through sustainability, social justice and ESG investing. (ESG stands for environmental, social and governance investing.) To be accurate, people don’t say you can’t make any money on these investments, just not as much money as you would if you didn’t factor in those considerations when picking your investments. Let’s put this to rest right out of the gate. John Hale of the renown MorningStar investment research firm has said that’s not true. And Morgan Stanley’s Sustainable Reality: Analyzing Risk and Returns of Sustainable Funds survey came to the same conclusion. It determined that the returns of sustainable funds were in line with comparable traditional funds by looking at the performance of nearly 11,000 mutual funds from 2004 to 2018. In fact, the report concluded that there were no statistically significant differences in total returns. An interesting kicker was that the sustainable funds may offer lower market risk. These funds experienced a 20% smaller downside deviation than traditional funds. If you’re like most investors, the downside is what you find scary, not the upside.
For this first article on socially responsible investing, we’ll look at two topics related to getting started: advisor selection and investment screening. We’ll also cover one benefit of ESG investing: risk mitigation.
If you’d like to pursue (or even explore) socially responsible investing with an advisor, you’ll need a particular type of advisor. Margaret Towle’s “Environmental, Social and Governance Investing: Myths versus Reality” discusses the problem with advisor selection. Many advisors simply don’t believe good returns are possible from these types of investments. Therefore, they have not researched them. Some of them are with companies that don’t have agreements with a diverse number of mutual fund managers, resulting in fewer choices. That lack of choice can affect how they perceive any mutual fund manager, much less one focused on ESG investing or sustainability. While you may be part of the majority who are interested in evaluating these investments, the advisors do not bring up the topic. In one study 60% of the times that a conversation around socially responsible or ESG investing was brought up, the investor raised it, not the advisor.
If you are interested in making this type of investing part of your portfolio, you should interview advisors to find out their feelings on the topic and evaluate how much they know. Oftentimes they have points of view that are not substantiated by research.
Along with finding a knowledgeable advisor, it is important that you and the advisor are talking about the same thing. I often use the term values-based investing. However, this can also be called socially responsible, sustainability, impact, social justice, faith-based or environmental, social and governance investing. This may explain why the topic is so confusing.
Consider this chart from Nuveen found in Towle’s “Environmental, Social and Governance Investing: Myths versus Reality” which provides a framework for what some practitioners mean by the different terms.
Adasina Social Capital offers a complement to those definitions towards introducing a new term, social justice investing.
That said, it’s often better to have a conversation and come to an agreement on terminology rather than assuming that a term means the same thing to you and your advisor. Values-based mutual fund and exchange-traded fund companies provide a fact sheet with their top 10 holdings and often provide a document that shows all of their holdings. It is not uncommon to see companies such as Microsoft MSFT , alphabet (Google GOOG ), and other household names on the list. Your perception of those companies may be that they have nothing to do with your values. However, if you were screening say for gender equality using some of the research companies mentioned here, you might be pleasantly surprised by some of these companies’ policies toward female employees. In fact, when you quickly scan a fact sheet, you may be in disbelief that a certain company shows up or surprised that another company is not on the list.
There are many different methodologies for defining what fits in a category. Companies offering values-based investment research include Calvert, MSCI MSCI , As You Sow, OpenInvest, YourStake and Morningstar’s MORN Sustainability Ratings, just to name a few. Some of their tools are proprietary, i.e., available by subscription typically to investment advisors and portfolio managers. But As You Sow has a publicly available tool that you can use to screen many investments for a variety of categories, including gender equality and prison-free investments. Most of these companies focus exclusively on research, but Calvert also provides mutual funds. MSCI does not provide mutual funds or exchange-traded funds, but some investment companies create funds that track MSCI’s indices.
It’s interesting (and potentially frustrating) that you can evaluate a fund or company against a category that means a lot to you—such as being fossil fuel-free—and find that it gets an A grade, but that same fund may get an F in some of the other categories that As You Sow evaluates. When you look at the reasoning behind the grades, you may not agree. For example, you may feel that not investing directly into prisons through real estate or active management is enough for you. But As You Sow’s methodology evaluates other aspects of the topic that might result in your favorite fund receiving a failing grade. This is their definition of prison-free investing—“The prison industry screen flags companies involved in incarceration and detention facilities (including facility management, youth and family detention, private facilities internationally, private prison financing, transportation and deportations, facility surveillance and security, and prison labor), services in facilities (including communication services, health services, banking and financial services, and food, commissary, and other goods), and supervision and monitoring (including e-carceration, community corrections, and bail bonds).” They also include border industry screening. In the end, you as the investor must make the decision.
Finally, the other factor to consider when screening investments is their degree of commitment to socially responsible investing. Morningstar’s sustainability ratings include whether or not a mutual fund has a mandate to be sustainable. If a fund is not required to be sustainable at all times, it may end up holding the very thing that you don’t want it to hold. You may also find that some funds indicate by name that they are an environmental, social and governance fund. Even so, I recommend that you use a tool such as As You Sow to see if the fund matches your values.
I know some people who have become frustrated trying to line up their social values with their investments. To avoid this, I recommend going into your search recognizing that you probably can’t align your values and investments perfectly. Even so, aligning them as closely as possible will make you feel better—and will benefit society.
The goal of ESG investing is to provide suitable returns and benefit the greater good. One of the ways it does this is by minimizing risk. Companies can do only so much to protect against unexpected external events such as a pandemic. But they can do a great deal to guard against internal problems that would damage their brand and lead to bad publicity, resulting in a poor investment return. By definition, companies with high scores for environmental, social and governance factors mitigate this type of risk.
While not discussed often, corporate governance (the G in ESG) can quickly take a stock’s price in the wrong direction. Bad public relations that result from taking advantage of customers or doing other types of illegal activities fall under the governance heading. Lawsuits from unhappy female and minority employees aren’t good for business either. Paying money to clean up the environment due to a company’s mishaps also increases risk. I have found over the years that considering these factors has been good not only for the conscience but also for the volatility of the account balance.
So far, we have covered how to get started in ESG investing and reviewed one of its financial benefits. In my next article, I will discuss the role investment platforms play and the importance of having a wide range of options for socially responsible investing.