Investing has never been an industry to shy away from buzzwords and acronyms, especially when it comes to a hot new trend. For those of you interested in the increasingly popular sphere of socially responsible investing (SRI) – a broad term representing a wide variety of strategies that consider not only financial return but social and environmental impact – – the associated mess of jargon can make the search for investments seem overwhelming. SRI is still in its nascent stages and the creators of funds and ratings systems all define “social responsibility” a little differently, which is not only confusing but also can make it hard to trust that you are getting investments that line up with your values.
However, over the past few years, the industry has begun to agree on some basic terminology and categories of investments. This rough framework will hopefully lead to a greater understanding of existing options and new ideas to come. Though things continue to evolve at a rapid pace, getting a grasp of the following concepts is a good place to begin.
Environmental, Social and Governance (ESG) Indicators
Seeing ESG in the name of a fund might cause you to incorrectly interpret it as an ethical or sustainable investment. At its heart ESG is not a stamp of approval, but a system for measuring aspects of a company’s performance that are not typically found on a balance sheet. To date, MSCI (a leader in ESG research) has defined more than 50 ESG metrics that it sees as meaningful to the long-term outlooks for businesses – – from water use (E) to worker health and safety (S) to board diversity (G). It tracks data and issues ESG ratings on 8,500-plus companies. Much of this research rests on how willing or able companies are to provide information about their own activities. Companies that lack transparency or otherwise fail to provide accurate information are generally rated poorly.
Traditionally, the main approach for socially responsible investors has been to screen out or avoid companies or entire industries based on business activities that they deem objectionable, such as manufacturing alcohol, tobacco and weapons. More recently, this approach has also been used by investors to divest entirely from companies involved in the fossil fuel industry. Negative screens have gotten more sophisticated in the past few years by incorporating a wider variety of ESG indicators. This has allowed investors to be more specific about the activities they want to avoid in their investments.
Instead of weeding out undesirable names, positive screens seek to include companies with positive ESG performance. Often, this rests on the belief that there may be a link between ESG performance and long-term financial performance or business longevity. An ESG focus may help companies reduce risk, better manage resources and maintain the goodwill of society. ESG researchers also look at companies by industry and geography to understand which ESG metrics may be more meaningful for different sectors. Screens can be constructed to include the best of the best overall, the best in each industry or even look for laggard companies whose ESG performance has been improving.
Impact investing is a subset of socially responsible investing that targets companies working to solve social and environmental problems. Often these are the same problems that are outlined in the United Nations Sustainable Development Goals (SDGs), such as ending poverty and providing affordable and clean energy for all.
The SRI landscape is continuing to change with the current massive social and economic upheavals. While environmental performance remains a key differentiator of companies, we are seeing increased scrutiny of corporate social performance as companies diverge in how they are responding to COVID-19 and the demand for racial justice.
If recent events have you looking for ways to generate more than a financial return with your investments, talking to your advisor is a good place to start. We can help you define what socially responsible investing means to you and help you craft a strategy that’s in line with your values.