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Environmental, social and governance investing, known as ESG, is a hot topic as investors increasingly seek investment solutions that are aligned with personal values.
BlackRock CEO Larry Fink has become one of the more vocal proponents of ESG investing.
In his annual letter to CEOs, Fink characterized climate change as “a defining factor in companies’ growth prospects.” BlackRock announced plans to fully integrate ESG into its actively managed and advisory strategies by the end of 2020.
Enthusiasm about ESG investing is far from unanimous. Commissioner Hester Peirce of the Securities and Exchange Commission is among the skeptics expressing reservations about the use of ESG factors. In a speech titled “Scarlet Letters,” Peirce said, “the ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences.”
The growing universe of investment products carrying labels such as ESG, responsible, sustainable or impact creates confusion for consumers trying to make investment decisions.
Artisan Partners portfolio manager Dan O’Keefe shared his thoughts in a recent shareholder letter: “What is the meaning of ‘responsible’? Ask five people that question, and we suspect you will get five different answers.”
Clarity and consistency in naming would help investors, reducing the likelihood of major disconnects between expectations and outcomes.
ESG analytics provider MSCI defines values-based investing as an approach that “aims to align investments with an organization’s or individual’s ethical values by expressing preferences for what industries and companies they invest in. … Values-driven exclusions are not implemented for financial reasons.”
Many investment strategies described as socially responsible would fall under MSCI’s values-based investing definition.
Investors who want to align investment portfolios with personal values often gravitate to values-based exclusionary approaches.
For example, faith-based investors may exclude sin stocks such as alcohol, tobacco and gambling companies from their portfolios. Strategies that exclude fossil fuel energy and utility companies are appealing to many climate-focused investors.
Values-driven exclusionary approaches are easy to understand, with investors able to focus on inclusions and exclusions from the investment opportunity set. Investors in exclusionary strategies should understand the implications of avoiding certain industries or companies.
For example, fossil fuel-free strategies may lag behind market benchmarks during periods in which energy prices are rising and may have a performance advantage when energy prices fall.
Ultimately, a well-informed investor is likely to be a more satisfied investor.
ESG integration, as defined by MSCI, “aims to assess long-term financial risks and opportunities related to ESG issues as a core component of building a resilient and sustainable portfolio for the specific purpose of enhancing long-term risk-adjusted returns.”
There is typically an important philosophical distinction between values-driven exclusionary and ESG integration strategies. Exclusionary strategies will avoid certain industries and companies regardless of price, while an ESG integration strategy may find a price at which a company would be an appealing investment despite the ESG risks.
For example, a fossil fuel-free strategy would never own ExxonMobil Corp. (ticker: XOM) or Chevron Corp. (CVX) stock, while an ESG integration strategy could own either stock if the price was attractive enough to offset ESG risk considerations.
Board diversity and independence are important governance considerations for ESG investors. Employee engagement, community relations and labor standards are important social considerations, and climate change, water scarcity and pollution are important environmental considerations.
Although ESG considerations are often characterized as being nonfinancial in nature, today’s nonfinancial consideration could be tomorrow’s material financial factor.
Consequently, integration of material ESG considerations can help to identify future risks and opportunities. Wells Fargo & Co. (WFC), Experian (EXPGY), Volkswagen (VWAGY), Valeant Pharmaceuticals, CBS and PG&E Corp. (PCG) are prominent examples of companies in which ESG risks turned into financial losses.
Subjectivity isn’t necessarily anything new for investors. Just as there isn’t universal agreement about the valuation of a company, there may not be universal agreement about the ESG merits of a company. A company that gets high marks from one ratings firm may get dramatically different ratings from another, for perfectly legitimate reasons.
Some rating firms emphasize different ESG factors or may measure the factors in different ways. Competition among ESG ratings providers can be beneficial for investors, fostering innovation and offering distinct choices for investors who may have different ESG preferences.
The index investment universe offers a relevant parallel, in that competition among index sponsors provides investors the ability to choose between different approaches to defining the index.
For example, the Russell 2000 Index and S&P 600 Index offer very different universes for U.S. small company stocks. The different approaches to defining the small company universe gives investors the ability to make a choice about which index is a better fit for their portfolio.
It seems logical to encourage that same competition among ESG ratings providers.
Investors interested in ESG solutions should understand that positive ESG ratings aren’t a guarantee of investment success.
For example, the best performers in a well-known ESG index ETF in 2019 were familiar companies also included in leading non-ESG indexes: Apple (AAPL), Facebook (FB), Microsoft Corp. (MSFT) and Alphabet (GOOG, GOOGL).
Investors may be surprised at some of the companies commonly excluded from ESG portfolios, with Berkshire Hathaway (BRK/A, BRK/B) and Amazon.com (AMZN) among the most prominent examples.
Strong ESG ratings weren’t enough to overcome business challenges for many companies included in the ESG index ETF: Gap (GPS), Nordstrom (JWN), AbbVie (ABBV), Marathon Oil Corp. (MRO) and 3M Co. (MMM) were among the companies with qualifying ESG scores that nonetheless lagged far behind the market during 2019.
The technology sector, the market leader in recent years, has tended to be overweight in ESG indexes. And the lagging energy sector is either avoided or is underweight in ESG indexes.
A change in relative performance between technology and energy could negate the recent performance advantage of ESG indexes. A reassessment of the ESG merits of leading technology companies is another potential game changer, given controversies over privacy, labor conditions and antitrust.
Many investment managers claim to incorporate ESG considerations into investment decision making, but there is far from a uniform application of ESG in the investment industry. The guidance provided to investors interested in exclusionary strategies applies equally to investors interested in ESG strategies: A well-informed investor is likely to be a more satisfied investor.
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