Not a day goes by without an article published discussing how ESG is being embraced by the investment community. But if you ask 10 professionals to define ESG you get 10 different answers. So, what exactly is ESG?
First, everyone agrees ESG investing is an approach that incorporates environmental, social and governance (ESG) factors into the investment decision. Everyone also seems to agree ESG investing will somehow provide our children with a better future or, at a minimum, a more livable world.
So where’s the confusion?
I believe its centered around the motives behind the investment decision. Sometimes the primary motive is financial return while other times it’s about aligning values with investments.
In the diagram below I show the four flavors of ESG investing. Each flavor creates a positive impact but the motives behind the investment decisions are significantly different.
Socially Responsible Investing (SRI) combines financial returns with a moral or ethical mandate. SRI examines ESG factors through a moral or ethical lens before considering financial returns. Most ESG mutual funds fall within this category.
Example of SRI strategy: Bob wishes to foster diversity in the workplace. Bob invests only in companies having positive ESG diversity factors. Only after identifying companies that meet this criterion will Bob consider the financial aspects of the investment. This is an example of socially responsible investing because Bob put his values ahead of his return.
Investment Screening (aka negative/positive screening), adds or eliminates certain investments from the pool of investable securities solely based on one or more predefined ESG factor. Financial return is not factored into the selection or exclusion process.
An example of negative screening is when the investment managers exclude all firearms or tobacco companies from the investable universe. Positive screening includes funds that only invest in green energy companies or minority owned business. Government and religious managed assets often employee negative/positive screening.
Impact Investing is defined as making a measurable beneficial impact while also achieving a financial return. The success of impact investing is measured by its impact and not by its financial return. Depending on the speaker, impact investing is considered either as a separate category or under the ESG umbrella.
An example of impact investing: Steve wants to increase medical care access to low income neighborhoods. Steve looks to invest in medical clinics that will have a measurable impact on a specific community. He chooses from a range of KPIs to determine the success of his investment. KPIs can include neighborhood infant mortality rate, emergency room wait times etc. Steve also requires some financial return, but his primary objective is making an impact on the specific community. This is an example of impact investing.
Responsible investment (RI) uses ESG factors to enhance long-term returns, mitigate risk and identify opportunities, as evidence shows —firms that manage their ESG factors make better investments. In other words, RI uses non-financial ESG factors that are material to the company’s operations as an integral part of the investment process. Better managed companies tend to be more diverse, environmentally conscience and forward thinking than their peers. The trick behind this strategy is to identify companies that have or are willing to aspire to these qualities. RI is the most popular form of ESG investing and includes managers who actively manage over $40 trillion of AUM.
And an example of RI is as follows: Helen is an investment manager and includes in her analysis ESG factors that have a material effect on the company’s financial performance. Hellen currently is looking to invest in a professional service company, so she considers such ESG factors as business ethics, data privacy and employee engagement. After reviewing the data in conjunction with financial data, Helen makes an investment decision. This is an example of responsible investment.
All four flavors are labeled ESG investing but each style has a different primary motive, but all ultimately have a positive impact and make for a better future.
If you’re interested in learning more about ESG investing please contact Joe Holman at email@example.com.