Though I’m not qualified to give life advice, one thing I’ve learned through the years is that life is all about tradeoffs. For many decisions, the tradeoffs are obvious. Do I join friends for a beer or go for a run along the river? Admittedly, I don’t always make the most prudent decision on this one, but I do understand one path will lead to short-term gain, while the other will probably be better for me in the long-run (no pun intended!). Fortunately for me, (when I’m creative enough) the events don’t have to be mutually exclusive.
When it comes to aligning investor’s personal values with their investments, the tradeoffs aren’t as obvious. For many, investing the nest egg for retirement and making the world a better place are two separate missions. Traditionally, this approach involves the investor donating their time and/or money to causes they believe in, while investing their assets in strategies that optimize for profit, but not both. So the question is, can you achieve both objectives through your investment choices? And if so, how? Before we address this, let’s first provide some context.
What’s in the name?
Originally referred to as Socially Responsible Investing (SRI), the term is now often interchanged freely with Environmental, Social and Governance (ESG). There are many other terms, but these are the two most common.
Socially Responsible Investing (SRI)
The first SRI strategy, The Pioneer Fund, was established in the 1920s. Consistent with what was deemed socially taboo during that era, the fund’s objective was to eliminate any investments in companies earning revenue through Tobacco, Gambling and Alcohol. Indeed, most SRI funds employ a screening process that either places higher investment in or completely eliminates companies that don’t meet their mandate, which is typically narrow in focus (i.e. Tobacco). While straightforward, this approach can lead to greater concentration in portfolios and less diversification. Further, investing in multiple SRI funds with separate mandates (i.e. Tobacco vs. Oil) can lead to sub-optimal results because the anti-tobacco fund holds oil stocks and vice versa.
Environmental, Social and Governance (ESG)
ESG, SRI’s younger, more sophisticated brother, takes the value investing concept further both in mandate and effectiveness. Examples of ESG issues include:
Environmental: sustainability, waste management, clean energy
Social: workplace safety, gender equality, community relations
Governance: executive compensation, board structure, accounting oversight
With the expanded scope of mandates, ESG funds typically target companies that pass the mark in many of the issues listed above. Well-constructed ESG funds are now designed to provide a much broader exposure to stocks and employ robust scoring methodology that ranks companies by multiple target mandates, and then scores them across industries. From there, specific companies are over-weighted or underweighted, while still maintaining a high level of diversification. Compared to the binary nature of SRI screens (yes or no), a properly structured ESG fund can help investors further pursue their objectives.
But how does one best go about achieving the dual objective of 1) investing their money to help meet living objectives while also ensuring their investment dollars help impact their personal values (i.e. carbon emissions or gun control)?
If you’re struggling with this question, you’re not alone. According to a 2016 study by Natixis Global Asset Management that surveyed 951 employees participating in their company employee retirement plan, 82% stated they would like to have their investments reflect their personal values. The recent trend seems to be picking up the most steam with the younger generations. When analyzed by generation, 84% of Millennials responded yes compared to 79% of Baby Boomers.
Matching the increased desire by investor, investment dollars have flowed into funds with ESG mandates. As you can see below, there has been considerable growth dating back to 2005, and a whopping 33% increasing from 2014 to 2016.
To put the growth in perspective, according to the Forum for Sustainable and Responsible Investment (SIF), more than 1 out of every 5 dollars managed by professionals in the US is targeted towards an ESG (Environmental, Social, Governance) mandate.
Paralysis by Analysis
As expected, the asset management industry has been their arms wide open with new strategies to match the evolving investor preferences and interest in ESG strategies. According to the US Forum for Sustainable and Investment, as of 2016, there were more than 1,000 strategies with roughly half coming in the form of a Mutual Funds or ETFs (Exchange Traded Funds).
Even the cynic in me can recognize that enabling investors to align their values with their investments is a good thing. That said, as we’ve written about before, having too many options can be a bad thing for investors. So with more than 1,000 options available, how does one go about narrowing the landscape?
The primary reason most of our clients come to us is to answer their big questions – when can I retire? Can I sustain my level of spending through retirement? For this reason, we believe ESG strategies should start with data-driven investment principles in mind (well-diversified, low-cost, minimal friction, tilts towards proven factors, etc.). Once these filters are applied to the available ESG fund universe, the available strategies are reduced considerably, making the next step much easier.
From there, the available ESG strategies need to be assessed to determine if they match the investors value preferences. At this point, investors should have a much better understanding of any potential tradeoffs that come with the dual-objective approach.
If ESG investing is of interest to you, please get in touch.