Environmental, social and governance (ESG) investing has become a central theme across the financial landscape. The events of 2020 served as a tailwind, accelerating related trends that broadly drove strong performance and investor interest. Notably, asset managers are making headlines with ESG commitments, and ESG strategies are topping the fund-launch tables.
What is all the interest about? Here are three main categories of ESG investment strategies and key considerations.
1. Ethical or socially responsible investing
Ethical or socially responsible investing is not new. In fact, it dates back to acceptable investment guidelines from religious organisations more than 100 years ago. That base structure is still in practice today, as most ESG strategies exclude investments in enterprises deemed morally and ethically questionable. Typical examples are ‘sin stocks’ in the alcohol, tobacco, firearms and gambling sectors.
Among investors, a primary value of an ESG lens is knowledge their capital is not backing something they believe is unethical. This is an increasingly important consideration, and there are many socially responsible core investment strategies available in the market.
2. Integrated investing
With integrated investing, ESG considerations balance more traditional financial analysis. One approach is to consider ESG as a risk category — to help provide context on the fair value of an investment. For example, an enterprise might be considered to carry high ESG risk if it is associated with fossil fuels or munitions. These strategies will potentially still hold investment positions with high ESG risk if the valuation is attractive enough, an approach that sometimes causes confusion among investors.
Here, it can be helpful to consider an analogy between credit risk and high yield bonds. Most holdings in a high yield bond portfolio represent corporate bond issuers with high balance sheet leverage (i.e., a high proportion of their assets financed by debt) and are therefore a high credit risk. It is the investment portfolio manager’s job to determine whether the current valuation is compensating investors for that risk.
A focus on stewardship (i.e., engagement) can augment integrated investing. For example:
- Most forms of investing provide opportunities to engage with the people who manage a company’s operations.
- Equity investors can vote on company resolutions, and most large equity stakes will grant direct access to a chief executive or chairperson.
- Access to company management through debt investments (fixed income) is often considered to be less direct. But in cases of a closer relationship between lender and borrower, this avenue can be important.
In any case, there is an opportunity to encourage or press management teams to improve ESG performance over time. The value of this effort should not be underestimated, as there have been several cases of investors influencing significant changes in corporate behaviour.
3. Impact investing
This category started with a somewhat purist definition of investment strategies. This included directing capital to organisations providing clear solutions to an environmental or social problem and delivering a positive impact on society. There can be a range of themes in play, such as renewable energy, alternative forms of propulsion or better access to medicine, for example.
In recent times, the category has expanded with strategies for financing or encouraging change in broader economic activity. This still impacts society under certain themes, but the scope of companies to invest in is larger. For example, an equity investor in a traditional oil and gas company may use the stewardship avenue to encourage the company to transition the business toward cleaner sources of energy.
It would be remiss to not address the current challenges of ESG investing. Here are three considerations for investors:
- Sufficient data disclosure. Many metrics to track a company’s ESG performance are not disclosed consistently and, even when they are, there is often a significant time lag. As a result, investors must rely on estimates or conversations with management to fill in the gaps.
- Greenwashing. This means putting forward an investment as ESG-focused when really it is not. It can be very challenging for investors to assess greenwashing, particularly when considering integrated strategies that balance ESG risk against valuation.
- Future performance. There is increasing evidence of a positive relationship between ESG performance and investment returns, which is clearly encouraging. But it would be inappropriate to generalise to a logical extreme suggesting higher ESG credentials always will deliver a better financial result. There are often differences in systematic (market) risk profiles to consider. Investors must remember that systematic risk and expected return are linked.
Despite the challenges, it is our view that ESG investing is here to stay. Actively managed portfolios are particularly well-suited to the analysis and engagement that ESG investing requires. Your Ameriprise financial advisor can offer personalized recommendations for ESG funds or strategies that support your financial goals, risk tolerance and time horizon.