Socially responsible investing – now part of mainstream investing strategies
In the face of mounting social, economic, and environmental challenges, the investing public has become more thoughtful and strategic about where and how their investment capital is deployed. Increasingly, they aim to reduce their association with unsustainable or unethical business practices and increase investment in companies and projects in keeping with their values. This practice is commonly referred to as sustainable or ethical investing or, more broadly, socially responsible investing (SRI). SRI was once thought to be a fringe consideration. However, it is now clearly a part of mainstream investing with approximately $1 of every $3 of assets under management in the U.S linked to some sort of sustainable investment practice.
SRI is by no means a new concept. Religious and ethical systems of belief have long influenced investment decisions. For example, Islamic tradition in accordance with Shariah law requires Muslims not to invest in forbidden or exploitive activities. As written in the Old Testament, under the notion of Tzedek (justice and equity), owners have rights and responsibilities to ensure that their holdings are not used for harm. Quakers and Methodists in the 18th century developed the first ethical investment vehicles, trusts which formally avoided investments in slavery and war.
Principles of modern SRI
Principles of modern SRI took form in the early 20th century, led by investors avoiding or disinvesting in “sin” stocks of companies dealing in alcohol, tobacco, and gambling. In the late 1960s, student protestors of the Vietnam War pressured university endowments to disinvest from companies that profited from the war. The civil rights movement raised awareness about the enmeshment of racial, social, and economic issues, encouraging corporations and investors to consider their role in society beyond profitability.
In the 1980s, ecological disasters such as Chernobyl and the Exxon Valdez pushed environmental concerns into the mainstream. Coupled with the United States Sustainable Investment Forum in 1984, a more standardized approach to SRI was introduced, which provided investors with a set of metrics to measure and construct portfolios that could be compared to traditional investments.
Over the coming decades, investors, regulators, and public companies would continue to develop ethical, social, and environmental metrics to identify “good” and “bad” actors or companies. With the public now able to evaluate a corporation’s workforce policies or environmental impact, corporations have come to appreciate that being a force for good is good for business, and good when raising capital.
ESG – the most ambitious SRI framework
The latest (and arguably the most ambitious) SRI framework to date is Environmental, Social, and Governance (ESG) investing, which establishes metrics across these three domains. Environmental criteria measure corporate performance on environmental challenges such as waste, pollution, greenhouse gases, deforestation, and climate. Social criteria evaluate the treatment of employees and communities through the examination of human capital management, workforce diversity, equal opportunity, as well as working conditions and health and safety. Governance criteria consider how a company is managed by assessment of remuneration of executives, board diversity, and corporate voting structures.
A company’s success includes a spectrum of stakeholders
In the spirit of SRI, ESG investing recognizes that a company’s success includes a broad spectrum of stakeholders, beyond shareholders. However, while earlier iterations of SRI advocated for avoidance or disinvestment, ESG proposes an ethical framework of metrics which can be considered alongside financial metrics to identify and assess value as well as risk. Advocates of ESG investing propose that ethical investing and market returns are not mutually exclusive. Rather, companies are more likely to achieve success if they create value for all stakeholders including employees, the environment, and society. In addition, ESG metrics provide targets for companies to align themselves with best practices and evaluate their own performance against their investors’ standards. This is a means by which investors can influence and impact future performance.
The need for standardized metrics
While the ESG investing framework does not have to limit its investment universe, it creates the challenge of developing comparable and standardized metrics to benchmark performance. At the moment, no such standard exists, and reporting is largely volunteered or derived by third parties. There is no universal, established, and comparable framework as robust as those required to measure financial performance. Some inroads into the world of sustainability reporting include the Task Force on Climate-related Financial Disclosures (TCFD) or Sustainability Accounting Standards Board (SASB). However, the absence of a uniform framework means that information provided may be subjective and difficult to compare between companies and across sectors.
Furthermore, some ESG domains are not easily codified. For example, environmental standards for pollution or carbon use can be quantified and shared metrics for these have been stablished through decades of work by scientists and companies. But social and governance values are notably more abstract and also require the imposition of a value system that are not always shared or easily translatable into material financial value. Similarly, is the ‘E’, ‘S’ or ‘G’ more important than another? How does one compare the value of a material factor to an immaterial one?
ESG investing is a relatively recent innovation without a meaningful track record, so it is difficult to confirm advocates’ claims that taking this approach will improve financial performance. Preliminary meta-analyses are optimistic as to positive performance over the long term, but only marginally. Notably, ESG inspired funds tend to perform better on the downside, which supports the claim that ESG-oriented analysis helps mitigate risk, especially in volatile or down markets. Also interesting, an ESG approach performed better than negative screening and/or divesting, suggesting that ESG-inspired engagement may help companies outperform over the long term.
The COVID pandemic has clearly expanded the aperture of how investors and corporations think about risk, opportunity, and potential pitfalls relating to factors such as workforce, public health, and the environment. ESG investing, while still suffering from a myriad of deficiencies, may offer one manner by which investors and corporations may start paying attention to, and simultaneously leverage and build, a broader set of ideals.