What Exactly Is ESG Investing & How To Go About Building A Socially Responsible Investment Portfolio?

ESG investing is currently the fastest growing philosophy and investment sector in the world. Almost 25% of institutional investment is now branded ‘ESG’ and retail investors, particularly younger generations of investors, are increasingly demanding that the asset managers they invest their capital with abide by ESG principles. And a large majority of industry observers believe that not only is ESG investing here to stay but that it will soon become an industry standard. Funds will have to comply with an ESG investment approach if they hope to attract mainstream institutional or retail capital.

And the rise of ESG investing is not simply a result of investors suddenly becoming all warm and fuzzy. There are pressing financial considerations at play too due to the growing influence of non-financial environmental and social risks on long term business performance. To name but the main ESG considerations - climate change, privacy & data security, waste management, labour practices, gender diversity and board independence all have a material impact on business operations in today’s world.

And that influence is only expected to grow going forward. ESG investors want to put their money into businesses which are well prepared to deal with these complex risks as they believe that only by doing so do they stand a good chance of creating long term shareholder value. Research is increasingly showing that investing according to ESG principles can reduce portfolio risk and generate competitive investment returns, while still allowing investors to feel like the money they are earning is not coming at the cost of unsustainable or unethical business practises. 

A quick glance at the growth in net assets invested via ESG-branded ETFs in Europe, just one asset class, is enough for investors to grasp the future reality. Figures recently published by Lyxor ETF, the ETF manager owned by bank Societe Generale, showed that by May this year, inflows into ESG-branded ETFs had already far outstripped the 2018 total over the whole twelve months of the year.

Source: Lyxor ETF

What Exactly Is ESG Investing?

So we know ESG investing has rapidly become the strongest investment trend internationally. But how exactly do companies prove that they are ESG-compliant and suitable to be invested in by ESG-compliant vehicles?

The letters that for the "ESG" acronym stand for Environmental, Social, and Governance. To qualify as ESG-compliant, companies, or any of the other forms of organisation that can offer investment vehicles, such countries that sell debt in the form of bonds, must demonstrate that the way they operate has a sustainable and ethical impact across those three key spheres of influence.

Environmental Sustainability

To qualify as compliant with the ‘E’ of ESG, organisations should demonstrate their business activities do not have a long term negative impact on the environment. Or that they have a clear policy in place, which is being acted upon, to mitigate and reduce that impact.

The latter qualification is often controversial and there is no one clear definition of what it means. For example, not all ESG vehicles automatically disqualify investing in companies in what would traditionally be considered ‘dirty’ industries that have been responsible for significant pollution over the years. For example, energy companies that derive the majority of their revenues from oil and gas or certain kinds of heavy industry.

As long as companies whose business activities undeniably still result in the release of significant levels of harmful emissions are perceived to be making enough effort in terms of their policy and a making a high enough level of investment into new technologies or other strategies to reduce their carbon footprints over time, they might still be considered as ‘E’ compliant. That could qualify a major oil and gas company that has also invested significantly in renewable energy and in mitigating the negative environmental impact of its fossil fuels business, even if that is the company’s core business activity, as ESG compliant.

However, other ESG-branded investment vehicles operate a stricter policy and would not invest in a company that was a heavy polluter, regardless of steps being taken to reduce pollution levels.

That grey area means individual investors, and institutional investors, should first define what their own belief system and red lines are. And then assess whether all ESG-branded investment vehicles being considered have compatible criteria.

Outside of controversial sectors, ESG investors will look at how progressive a company’s practises and policies are when it comes to considerations including, and outlined by investment media The Motley Fool, as:

• Climate change policies, plans, and disclosures.
• Greenhouse gas emissions goals, and transparency into how the company is meeting those goals.
• Carbon footprint and carbon intensity (pollution and emissions).
• Water-related issues and goals, such as usage, conservation, overfishing, and waste disposal.
• Usage of renewable energy including wind and solar.
• Recycling and safe disposal practices.
• Green products, technologies, and infrastructure.
• Environmental benefits for employees such as cycling programs and environmental-based incentives.
• Relationship and past history with the U.S. Environmental Protection Agency (EPA) and other environmental regulatory bodies.

Social Responsibility

The ‘S’ of ESG investing stands for ‘social’, or more precisely, social responsibility. It means the company has a policy and practises that protect and promote the rights and wellbeing of not only its direct employees but also that of suppliers and customers. As well as business activities not resulting in side effects that would be considered negative for society as a whole.

One example of the latter could be, and is generally considered, tobacco companies. An ESG investment vehicle would not be expected to invest in a tobacco company because of the negative impact smoking tobacco has on the health of those who buy it. And even more importantly, because smoking is highly addictive. But smoking can also be considered as harmful to wider society – not only smokers. The emotional and practical impact of losing family members and loved ones to smoking-related illnesses or diseases. The cost to the tax payer of the medical care smokers can need as a result of their habit. The fact that cigarette butts are one of the most common kinds of litter found discarded in towns, cities and even the countryside and so on.

To comply with the S of ESG, companies are also expected to not work with suppliers whose business practises could be considered socially negligent. For example, fashion brands whose garments are manufactured by suppliers running sweat shops or electronics brands who might work with factories where working conditions for their staff do not meet acceptable international standards. Mining companies, for example, would have to demonstrate high health and safety standards in their mines as well as policy and practises mitigating the environmental impact of their mines, to have a hope of qualifying as ESG compliant.

Social responsibility indicators looked at include:

• Employee treatment, pay, benefits, and perks.
• Employee engagement and staff turnover/churn.
• Employee training and development.
• Employee safety policies including sexual harassment prevention.
• Diversity and inclusion in hiring and in awarding advancement opportunities and raises.
• Ethical supply chain sourcing, such as conflict-free minerals and responsibly sourced food and coffee.
• Mission or higher purpose of the business (or lack thereof).
• Consumer friendliness, customer service responsiveness, and history of consumer protection issues including lawsuits, recalls, and regulatory penalties.
• Public stance on social justice issues, as well as lobbying efforts.

Governance

The ‘G’ of ESG stands for ‘governance’, with the context of corporate governance. It basically means that a company’s board of directors and upper management make sure the business is run in a way which is in the interests of shareholders – not management. Basically, does the company’s board and upper management look after the interests of the business’s various stakeholders, run it well and are corporate incentives structured in a way that is aligned with the long term success of the business? If the answer to those questions is “yes”, the company will be considered to demonstrate good governance and be compliant with the ‘G’ of governance.

However, if a company’s board and management is considered to be financially rewarding itself in way that is not commensurate with performance, sector norms or the company’s long term sustainability and interests, or prioritising the short term in a way detrimental to the long term, governance would be considered poor. And not ESG compliant.

Governance metrics looked at for ESG compliance include:

• Executive compensation, bonuses, and perks.
• Compensation tied to metrics that drive long-term business value, not short-term EPS growth.
• Whether executives are entitled to golden parachutes (huge bonuses upon exit).
• Diversity of the board of directors and management team.
• Board of director composition regarding independence and interlocking directorates -- which can indicate conflicts of interest.
• Proxy access.
• Whether a company has a classified board of directors.
• Whether chairman and CEO roles are separate.
• Majority vs. plurality voting for directors.
• Dual- or multiple-class stock structures.
• Transparency in communicating with shareholders, and history of lawsuits brought by shareholders.
• Relationship and history with the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.

Why Invest According To ESG Principles?

ESG is the counter point to the 1970s Friedman Doctrine that argues the only social responsibility companies have is to maximise shareholder value at all costs. The ESG philosophy is more holistic and longer term. It holds that a short term approach to optimising profits should not put longer term sustainability at risk. The logic is that pursuing short-term gains at the expense of long term sustainability is not, as the Friedman Doctrine would argue, the best way to build long term shareholder value. ESG principles argue that chasing short-term market approval at the cost of, for example, disenfranchising employees, taking unnecessary risks or even breaking the law, is not in the long term interests of sustainable profitability.

How Does ESG Investment Work?

ESG investing is often grouped together with Socially Responsible Investing (SRI). But there are important distinctions. An SRI approach to investing actively excludes companies and sectors whereas ESG is an ‘opt-in’ approach. For example, and SRI fund would simply blacklist investing in any companies in particular sectors, such as oil and gas, mining, heavy industry etc. Whereas an ESG fund might invest in ‘best practise’ companies in those sectors it judges to demonstrate progressive environmental, social and governance policies and practises.

On the one hand, that can mean ESG investment principles more confusing at first glance as they are less black and white than those of SRI. That can also be the source of criticism of the investment choices made by certain ESG investment vehicles. However, ESG offers more flexibility and looks at a company’s management patterns and corporate initiative in a more granular way. It could be considered more ‘practical’.

For example, ESG will usually not consider metrics such as how much money a corporation donates to charity – because it’s not directly related to the company’s sustainable profitability. However, it will examine a company’s policy and its execution around climate change on the principal that it is a factor the long term effects of which will impact corporate profitability in years to come. ESG also judges a company’s qualities within the context of their industry and sector rather than operating according to fixed principles. For example, an ESG fund will dig deeply into the data security policy and practises of companies whose business is consumer facing – like digital platforms or online retailers.

An industry that would be a complete no-go zone for an SRI fund, such as defence, could contain companies that an ESG fund would consider. For example, a company that designs and manufactures missiles but was strong on environmental sustainability, employee care, diversity and corporate governance could be considered as ESG-compliant. But there are no official standards that all ESG investment vehicles adhere to, placing an onus on investors to look into the policy and criteria of individual ESG investors.

Why Invest In ESG Assets?

In addition to ethical considerations and the desire of investors to invest in a way that reflects their personal values system, there is also a purely financial rationale to ESG. It helps reduce investment risk. Climate change poses an existential threat to entire economies and threatens to make many natural resources significantly scarcer.

When it comes to the treatment of staff, research shows treating employees well and keeping them engaged with their work helps business operations and long term bottom line performance. Gallup research has shown that companies which excel at engaging their employees achieve per-share earnings growth more than four times higher than rivals who do not. The top 25% of companies, ranked by how well they engage their staff, also demonstrate markedly superior customer engagement, productivity, staff retention, fewer accidents, and 21% higher profitability than the bottom 25%.

A strong policy on diversity that span’s a company’s hierarchy has also been shown to pay off. Research has shown teams that lack diversity and are composed of individuals from similar backgrounds make worse decisions and, as a result, have weaker financial results. Of 366 public companies from across the UK, USA, Canada and Latin America, those in the top quartile for ethnic, gender and racial diversity were found to be more likely to achieve financial performance ahead of the national medians for their industry.

Good management and a long term strategy not blown off course in favour of the pursuit of short-term goals, it turns out, leads to a higher chance of success for a company.

Asset manager Arabesque that found that S&P 500 companies in the top 20% for ESG compliance outperformed those in the bottom 20% by more than 25 percentage points between the beginning of 2014 and the end of 2018. The high-ESG companies' stock prices were also less volatile. 

Are There Risks Involved In An ESG Approach To Investing?

ESG, like any investment approach, is not without any risk. Investing in ESG-branded vehicles or shares in companies that rate well on ESG criteria does not guarantee returns. There are also a few ESG-specific pitfalls to be aware of. One is that a lack of defined standards mean investments that may not stand up to closer inspection or fit all definitions of the label can be defined as ESG. Another is that as more money flows in to ESG-branded funds and the approach mainstreams, there is a danger that companies and fund managers will exploit the term’s marketing appeal more than they actually focus on implementing genuine ESG standards in keeping with the spirit of the classification system.

A further risk is a future change of sentiment, with companies regressing from attempts to become more stakeholder-centric and no longer reporting sustainability data. That would make it harder for ESG investors to find a good choice of high-performing ESG companies to invest in.

How To Build An ESG Investment Portfolio

The building blocks of an ESG investment portfolio do not differ materially to those of a general investment portfolio that does not consider ESG qualities. An ESG portfolio should still aim for the same level of diversity as any other portfolio and represent a level of risk that is in line with the investor’s personal financial situation and investment goals. The only major difference is that within that context, investments should also have high ESG ratings – a filter which narrows the field of choice.

The fact that certain industries and sectors yield less companies that are considered strong on ESG characteristics means that ESG investors need to be especially aware of portfolio diversity. Make sure you do not fall into the trap of a narrowly focused portfolio that doesn’t suitably spread risk across a wide variety of industries and sectors that react differently at different stages of the economic cycle.

Otherwise, a balanced, diverse ESG portfolio can be built from passive tracker funds that follow major ESG indices, rather than traditional indices such as the FTSE 100, FTSE All-Share or S&P 500. Or actively managed ESG funds. ESG investors who feel comfortable and qualified to do their own stock picking, and would do so in for a non-ESG portfolio, can also build their own DIY ESG portfolio from individual stocks. This requires sufficient knowledge, experience and time but also ensures ESG investments match the personal values of the investor. In the case of ESG indices and actively managed funds, investors should analyse their ESG-ratings criteria to be sure it is a close enough match to their own requirements.