ESG investing has come into focus in recent years as a new means of analyzing the capital markets for investors looking to align their portfolios with their own personal values. In this post, we’ll discuss what ESG means, some examples of ESG screening, potential benefits & drawbacks of the method, and current & possible trends in the ESG space.
What is ESG?
ESG investment screening and integration is the method of utilizing environmental, social, and governance factors to select securities whose corporate business models and values closely align with the investor’s. ESG evolved from the original practice of socially responsible investing (SRI). SRI investing initially began in the 1960’s to focus on investing in companies that contributed to causes like civil & women’s rights and anti-war efforts. The mantra of “doing well while doing good” and having portfolios that represent their values were the focus, and SRI provided the framework that would grow into ESG.
The environmental component could include the company’s carbon footprint, waste & resource management, pollution, natural resource conservation, evaluation & management of environmental risks, and relationship with the EPA.
The social component corresponds to the people-related elements of culture, issues – both within the company & greater society – that impact employees, customers, consumers, & suppliers, and community involvement.
The governance component relates to the board of directors, company oversight, and relationship with shareholders. Areas of interest for this component might include executive compensation packages, diversity & inclusion on the board & in management, separation of chairman & CEO roles, dual/multiple class stock structures, and the company’s relationship with governmental regulatory agencies.
Investors can use resources such as the Global Reporting Initiative’s (GRI) sustainability database, the Principles of Responsible Investment (PRI) library, and scores from the United Nations Global Compact to make informed decisions. Other resources investors can utilize for the social criterion are Fortune’s “Best Companies to Work For” and the Forbes’ “Just 100”. Some investors even utilize the website Glassdoor to gauge how current & former employees receive the company & it’s management. Investors can also find most governance questions answered in annual proxy reports and annual financial statements.
Example of ESG Implementation
When S&P Global began constructing the S&P 500 ESG Index, a very specific set of criteria were used for implementation. S&P focused on eliminating companies that fit the following criteria:
- · Produced tobacco, derived more than 10% of revenue for tobacco, or held more than 25% of ownership in companies related to these activities;
- · Were involved in controversial weapons (i.e. cluster weapons, land mines, biological & chemical weapons, white phosphorus weapons, or nuclear weapons; companies holding more than 25% of ownership in companies involved in these activities;
- · Had a score in the UNGC database and were in the bottom 5% of overall scores;
- · Had a proprietary S&P DJI ESG Score in the bottom 25% of scores within GICS industry group.
- · Not in the top 75% of market capitalization of industry group.
This screening resulted in 154 members with a total weighting of approximately 24.5% of the S&P 500 being excluded. chart for corresponding exclusions & parent index market cap.
When back tested against the parent index, performance was nearly mirrored and better for the S&P 500 ESG Index in two the three return periods.
Benefits of ESG
Proponents of ESG screening & integration hypothesize companies on with an ESG focus will outperform those who do not. In the case of the S&P 500 ESG Index, S&P Global showed a strong performing portfolio can be constructed using ESG principles, even when eliminating more than 30% of the parent index’s constituents. Additionally, with a shift in younger investor’s mindset, companies are being tasked with hiring management teams focused on ESG factors, casting long-term vision for their companies, rather than chase short-term, quarterly profits.
Another benefit, and perhaps most important, is the personalized approach to build an ESG portfolio. While individual ESG factors are important, some investors incorporate personal cause specific screens, such as eliminating firearms & tobacco-related companies as shown in the S&P 500 ESG Index, further personalizing the portfolio. ESG investors are intent on “doing well while doing good”, willing to sacrifice absolute, total return in exchange for a portfolio molded on their personal core values.
Customizable ESG Screens
One limitation of ESG screening & integration is the lack of consistent process across the industry. While an individual can thoroughly utilize the tools listed above to screen for individual equities, vetting mutual funds & ETF’s can be a much more intensive statement. Investors need to utilize the available prospectus & investment policy statement for a giving offering to fully find one to their liking that matches their individual principles & values.
Another issue is the elevated costs associated with ESG investment managers. Even as fee compression affects the space, ESG funds & ETF’s tend to have higher expense ratios than traditional style & sector investment vehicles. Additionally, while the investor would see the positives in building a portfolio individualized to their values & objectives, advisors might find the task for each client burdensome.
Some current & coming trends for the ESG space are exciting. As more low-cost ETF providers enter the space, the method is becoming more cost effective for the average investor. Recently, Blackrock & Vanguard have both launched low cost ESG ETF’s with expense ratios under 20 basis points. This product availability should encourage actively managed vehicles to become more cost focused. Also, as it stands currently, proponents are actively campaigning for the SEC to require specific ESG disclosure requirements to make the screening & implementation tasks less tedious. Currently, the SEC is actively comparing information companies provide voluntarily with their SEC disclosure to determine what would be necessary.
The ESG movement is a rapidly growing movement. In the first two months of 2019, Morningstar tracked $180mm flow into ESG ETF’s. As the space continues to grow, it’s important to continue to monitor the movements & developments in the space, in order to keep passionate ESG investors & their portfolios abreast and ahead of potential challenges and opportunities.
First State Trust Company believes in supporting our clients to the fullest. Our most passionate clients can access ESG screening & implementation by utilizing one of our partners as an individual portfolio manager or using ESG mutual fund and ETF managers through a proprietary management platform. Our alliance partners each have ESG capabilities to manage trust portfolios. If you have any questions or are looking for an appropriate solution, please reach out to me at the email address below.
AVP, Investment Officer
The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.