A High-Level View of ESG Investing

At Four Ponds, we offer our clients the option of investing in a way that takes into account concerns they might have about environmental, social and corporate governance issues. ESG investing, also sometimes called sustainable investing, is an evolving field that remains in search of clear definitions and criteria. To help bring more clarity to this area of investing, we offer the following article written by our outside investment consultants at East Bay Investment Solutions.

A High-Level View of ESG Investing

By Mario Nardone, CFA, East Bay Investment Solutions

The idea of investing according to Environmental, Social, or Governance (ESG) values continues to gain momentum, yet the terminology itself can lead to confusion among investors. For example, some people use the terms “ESG” and “Sustainable Investing” interchangeably, while others use “sustainable” to refer specifically to environmental issues. Some use the terms “ESG” and “SRI” (Socially Responsible Investing) interchangeably, while others see a distinction. We don’t suggest that any of these ways of looking at it are wrong, but we do encourage thinking and speaking about it in consistent terms. For this piece, we are going to refer to ESG in a broad sense, unless otherwise noted.

Beyond just the definitions, there are mountains of data, hundreds if not thousands of academic pieces, and a seemingly infinite number of opinions on the topic, yet it seems there may never be a consensus on whether to employ it, or perhaps more importantly, how.

We are not here to settle any debates or draw definitive conclusions, but we would like to shed some light on the topic and introduce some different aspects and approaches to ESG investing. For the purposes of this piece, we will focus on equities, but most of it also applies for investing in bonds, real estate, etc., which have unique challenges of their own when it comes to ESG.

Approaches to Incorporating ESG Preferences

There are various approaches to incorporating ESG preferences into one’s investments. One of the most debated points is whether it is better to exclude companies from the portfolio if they do not espouse one’s ESG principles (known as a “negative” screening), or to channel assets only to the leaders in these areas (“positive” screening).

Another approach altogether is to invest and take an active role to influence the companies’ policies and practices (sometimes called “activist” investing or “shareholder engagement”). This method has gotten a lot of attention recently, when the activist investor Engine No. 1 won seats on the board of ExxonMobil to influence the energy giant to diversify further into renewable energy. If you are using a professionally-managed investment vehicle, like a mutual fund or ETF, you may want to inquire with the manager about their engagement practices in regard to its portfolio holdings. Nuveen, for instance, regularly publishes a Responsible Investing Engagement Report, which describes their policies in detail, as well as provides data on their activity and case studies.

Still another version of ESG implementation is known as impact investing, which invests in projects that are exclusively focused on a specific positive outcome. One example of this is buying a “green bond” issued by a firm to fund construction of wind and solar projects to power its facilities. Another example is an investment in a company that locates its production facilities in impoverished areas, thereby bringing employment opportunities to the local population.

All of these approaches have merit, for sure, and many strategies may overlap. The decision of which to choose depends really on investor preferences and the prevailing opportunity set.

Challenges of ESG Investing

While it seems straightforward on paper, one component for consideration is whether or how to weigh one of the ESG factors over another. For example, what if a company is lauded for its environmental record, but does not do well in governance areas such as gender or racial diversity? In this scenario, an investor taking the popular “Fossil Fuel Free” approach would likely not want the same holdings as one whose primary interest is to see more female directors and officers at their portfolio companies. Once you include all the different preferences investors might have, and consider that the “E,” the “S,” and the “G” have dozens of individual sub-categories each, you can see there are many combinations and iterations of approaches to ESG. Finding companies that score well across all the measures is very difficult and could lead to an undiversified portfolio.

Even after determining which approach to utilize, a significant challenge for any ESG investor is whether and how they can perform the required due diligence. One only needs to consider the Volkswagen emissions scandal from a few years ago as an example. On the surface, VW looked like the darling of the auto industry for environment-minded investors based on their emissions scores, but then it was disclosed that they cheated on the tests. The depth and breadth of the scandal was enough to generate concern that similar “greenwashing” may be happening and going unnoticed. How, then, is a Main Street investor supposed to have the access and knowledge to uncover such a devious plan by the likes of Volkswagen?

Fortunately, the emergence and increasing acceptance of quantitative scoring services like those developed by Morningstar, MSCI, and others, have helped revolutionize the ESG landscape, though their output must be understood and accepted rather than blindly implemented. In particular, consider a large oil company that gets poor ESG scores because of its fossil fuel production, but the screening tool doesn’t give it positive credit for a massive investment in clean energy technologies. This company’s investment might have the largest contribution to a clean energy revolution, but it might not be held in portfolios based on quantitative scoring. There are further complications when comparing companies across sectors, or comparing funds or ETFs across categories, and other apples-to-oranges scenarios. That said, as you’ll read later, these scoring services can still be helpful when creating and maintaining ESG portfolios.

Implementation Considerations

A practical factor to consider is how investors can effectively implement their ESG views while constructing their portfolios. The past few years have seen a significant increase in interest in ESG among investors and advisors, and the market has responded with a dizzying array of resources to help. Let’s take a look at some of the ways one might implement an ESG approach, from most specific to most broad, barring of course, the investor doing his or her own “boots on the ground” research investigating specific companies.

For investors with a very specific value they wish to focus on (say, social justice or renewable energy), or a personalized combination, there are tools and resources available that allow them to screen universes of stocks to isolate companies that fit their criteria, and/or remove those that don’t. This has existed for years in the Separately Managed Account (SMA) market, and there are now tools advisors can use to do it themselves. The latter falls into the realm of “direct indexing,” which is a hot topic among the advisor community but has yet to achieve widespread adoption.

While a separately managed account is an option for some, the minimum investments can be too high for others. Furthermore, it may not be possible to invest according to a specific set of values across all parts of the portfolio, such as international small-cap stocks, emerging markets, or REITs. This challenge applies to SMAs and direct indexing, as does the question about whether the investor wants to see hundreds or potentially thousands of individual positions on their account statements. The inability to trade fractional shares on custodial platforms also hinders the direct indexing approach today.

The next implementation option involves the mutual fund and ETF universe. With the accelerating increase in interest in ESG, we have seen many new fund and ETF launches hoping to quench the thirsts for the vast array of flavors of ESG. For instance, if the investor wants to exclude companies involved with oil production, there’s a fund for that (a number of them, actually); if they want only companies with a high ratio of females in their leadership, there’s one for that, too. Similar to the situation with SMAs, though, most of the available fund and ETF choices with a particular area of focus only exist for the large cap segment of the US market, so implementing a specific ESG goal across an entire portfolio can be elusive.

In our experience, the most widely used approach to ESG investing among the advisor community is to build portfolios using funds and ETFs that broadly screen their respective investable universe, rather than identifying a specific subset of ESG values. For example, multiple ETF providers have offerings across equity sub-categories (US Large, US Small, Developed Markets, Emerging Markets, bonds, etc.) that leverage benchmarks derived from MSCI’s proprietary ESG methodology. This allows advisors to tailor portfolios according to their investment preferences with a consistent and well-documented ESG methodology across investment categories.

There are clearly some tradeoffs when taking a broad-based approach. Specifically, it is not likely that broad screens will completely satisfy investors wishing to focus on particular values. For example, an energy company might score poorly on environmental factors, but could receive high scores for corporate governance and other issues, and possibly end up with a reasonably high overall score. Investors with a climate preference, then, might wonder why an oil company is in the portfolio. If they want to focus on a specific issue, a broad-based approach is probably not right for them.

It must be noted that all scoring mechanisms aren’t created equal, and the fund/ETF managers themselves might even take different approaches to implementing similar methodologies, so there is still a lot of work to do to find the right methodology and products for you. To make matters more confusing, one well-known ETF provider even offers multiple versions of broadly-screened ETFs. One version has more stringent screening, filtering out more companies, and thus has better overall ESG credentials but doesn’t track its broad category benchmark as tightly; the other version goes lighter on the screens so that its returns deviate less from its target benchmark. Suffice it to say their naming convention doesn’t quite explain these differences, so you really have to dig in to understand what you’re getting with each.

In order to refine their search for the product that best meets their needs, advisors and investors have an increasing number of tools at their disposal to evaluate funds and ETFs such as the following, linked for your convenience, though this is by no means an exhaustive list. Note that some of these tools listed below require a subscription and/or may only be available to advisors.

ESG’s Impact on Investment Returns

Another widely debated topic is whether one might expect an ESG portfolio to outperform a non-ESG portfolio over time, all else equal. Sorry to disappoint, but we have no way of quantifying that or making a prediction one way or another. There once was a more broadly held belief that ESG investing led to inferior results. This was a time when there were typically much higher costs associated with ESG investing versus investments that did not require the additional level of research and analysis. Because costs are a major contributor to the reduction of expected return, it would have been reasonable to assume ESG investing might actually reduce expected return, but investors would have to choose to accept that tradeoff in exchange for investing in accordance with their values.

With the emergence of quantitative screens and other advancements creating efficiency in ESG screening, plus the proliferation of passive investing leading to reduced investment costs in general, there is no longer such a wide gap between the cost of ESG and non-ESG portfolios. There are certainly exceptions, but in general there are ESG options for cost-conscious investors. There is also a belief that companies can “do well by doing good,” implying that perhaps companies, and their shareholders, will be rewarded for keeping an eye toward ESG values, though this is difficult to quantify.

Conclusion

Despite the fact that we cannot know whether an ESG approach will outperform, we find it admirable when investors go the extra mile to invest according to their beliefs, and as long as the tradeoffs are acceptable, one doesn’t have to totally abandon his or her investment principals to do so. We continue to survey the rapidly changing landscape for new and improved ways to build portfolios that align investors’ portfolios with their values, and we are standing by to help.

References

Hotten, Russell. “Volkswagen: The Scandal Explained.” BBC News, BBC, 10 Dec. 2015

Lee, Jinjoo. “Exxon Mobil Activist Victory Isn't Really All About Climate.” The Wall Street Journal, Dow Jones & Company, 3 June 2021

East Bay Investment Solutions, a Registered Investment Advisory firm, supplies investment research services under contract.

This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. This document is intended for the exclusive use of East Bay clients, and/or clients or prospective clients of the advisory firm for whom this analysis was prepared in conjunction with the EAST BAY TERMS OF USE, supplied under separate cover. Content is privileged and confidential. Information has been obtained by a variety of sources believed to be reliable though not independently verified. To the extent capital markets assumptions or projections are used, actual returns, volatility measures, correlation, and other statistics used will differ from assumptions. Historical and forecasted information does not include advisory fees, transaction fees, custody fees, taxes or any other expenses associated with investable products unless otherwise noted. Actual expenses will detract from performance. Past performance does not indicate future performance.

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