REA University: Understanding ESG Investing

REA University: Understanding ESG Investing

November 01, 2023

REA University Explained
In the world of finance, new strategies and products (and acronyms) are the rule, not the exception. Continuing education is core to our mission - it’s essential that we intimately understand the landscape to ensure our strategies are optimized. ,. It’s also important that we invest in our clients knowledge as information proliferates. Thus, the idea for RiversEdge Advisors University (REAU) was born, whereby our blog will periodically take a break from regularly scheduled insights to break down investment concepts with one simple goal: inform.

ESG: An Introduction
Chances are, you’ve heard the term “ESG investing” in your travels and may have wondered what it entails. In this blog post we’ll define it, explore its many flavors, and examine its long-term effects on investment outcomes. Note - this is aimed to be an objective synopsis. Subjective commentary abounds on the topic... As with all strategies, the right approach depends on the unique circumstances and goals of the investor. We encourage consultation with a RiversEdge representative to figure out if the strategies mentioned herein are appropriate.

ESG: What It Means
At its core, ESG, or Environmental, Social, and Governance, is a framework that allows investors to deploy capital in a manner consistent with their values pertaining to one (or more) of the three aforementioned areas. As the name suggests, investors focusing on environmental issues are concerned with how responsible companies are when it comes to their impact on the environment and ecosystems. Investors focusing on social aspects typically care about a firm’s relationship with its internal and external stakeholders. Governance focuses mainly on accountability to shareholders and avoidance of conflicts of interest. Below are some common examples of ESG criteria for each category.


ESG: What Flavor Would You Like?

Now that we’re familiar with the various criteria and lenses for ESG investing, we’ll move on to some of the

Now that we’re familiar with the various criteria and lenses for ESG investing, we’ll move on to some of the common strategies and approaches for implementing them. We’ll touch on the following: negative screening, positive screening, shareholder engagement, and ESG momentum.

Negative screening involves sorting through companies and excluding certain names, industries, or even whole sectors from the portfolio depending on the preferences of the investor. Two simple and  common instances  would be to abstain from   allocating capital to companies that deal in fossil fuels (environmental) and  “sin stocks” (alcohol, tobacco, gambling) by mandate. Negative screening could also apply to countries or geographical regions. It is imperative that an investor employing negative screening is willing to accept meaningful deviations from benchmark performance, as exclusion of large swaths of the market can drastically impact returns.

Positive screening is typically  focused on an area/cause where one would like to make an impact with their capital. From there, companies are sorted based on available data surrounding the selected criteria – providers like MSCI, Morningstar, Bloomberg, etc. provide investment professionals with ESG data on companies. Screening can be broad (for example, an investor focused on climate change may choose to invest only in the companies with the lowest carbon footprint), narrow (for example, an investor personally affected by a rare disease may seek out biotech companies that research a cure), or somewhere in between.

Shareholder engagement in the context of ESG investing involves investors rolling up their sleeves and chatting with the companies they've invested in. They're like friendly nudges pertaining to important issues like the environment, social responsibility, and how the company is run. They might suggest ideas, throw in proposals, and even vote on things during shareholder meetings. The aim? To push the company in a good direction—towards being more eco-friendly, socially conscious, and well-managed, all in line with ESG values.

Some strategies get even more creative. Enter: ESG Momentum. These strategies aim to select companies that have done the most to improve their ESG standing – to make a sports analogy, think of it as a most improved player award. This approach aims to reward companies that are trying and achieving goals related to sustainability, board diversity, or some other metric. It also solves for a commonly cited issue when it comes to negative screening: whole swaths of the market aren’t excluded because in theory each sector has firms who have improved from an ESG perspective.

ESG Controversy: Greenwashing

The market of both consumers and investors focused on sustainability has grown significantly, and some businesses aim to take advantage of that trend through a practice called greenwashing. Basically, greenwashing is akin to dressing up in a shiny eco-friendly costume without changing what’s underneath. Firms may use buzzwords such as “green” or “sustainable” without being transparent about their true impact. If investors/consumers take the bait, the company can benefit from a higher stock price, higher sales, and a better reputation. Obviously, this can trip up investors who are genuinely trying to support businesses that are making a positive impact on society and the planet. To avoid investing in names committing greenwashing, it’s best to do extra due diligence, look at data from a 3rd party to confirm environmental impact, and/or consult with a financial advisor who is familiar with ESG strategies.

ESG: What Kind of Performance Can Be Expected?

Investors seeking to incorporate ESG objectives should be prepared for results that differ from a standard investment strategy. However, it doesn’t have to translate into  lower returns. Proponents of ESG investing argue companies that are on the ESG radar tend to be more forward-thinking. They're adapting to changes in the business landscape, like shifting consumer preferences and tighter regulations. Plus, they're often finding innovative solutions to global challenges, which can lead to some serious growth potential and, by proxy, some seriously good investment returns. While that may sound like a strong argument, long-term performance data (shown in Exhibit 2) suggests that MSCI ESG index performance is remarkably similar to standard index performance. Bad news for those who expect to hit an ‘investment homerun’, but good news for those who may want to invest alongside their values without sacrificing financial gains. Of course, this is just a broad index – we would expect the many different possible ESG strategies would yield a wide array of results depending on how much customization and deviation from the benchmark takes place.

EXHIBIT 2: All Country World Index ESG Leaders Performance

At its core, the concept of ESG investing revolves around putting your money where your values are - the Environment, Social responsibility, and Governance practices. This arena offers a variety of ESG strategies, like filtering out the negatives, getting hands-on through engagement, and riding the ESG wave. It's like finding a personalized approach for your financial choices. The article digs into the question of how well these investments perform, using data from the MSCI ESG Leaders Index. Surprisingly, it's not so different from the regular index performance. This suggests that while ESG investing adds its own flavor, blending your beliefs with investments doesn't mean giving up on financial gains. In a nutshell, the article is your compass to navigate the ESG landscape, dishing out insights to ponder while you go for investments that balance sustainability and profitability in the real world. 

There are potential limitations associated with allocating a portion of an investment portfolio in ESG securities. The number of these securities may be limited when compared to those that do not maintain such a mandate. ESG securities could underperform broad market indices. Investors must accept these limitations, including potential for underperformance. Correspondingly, the number of ESG mutual funds and exchange traded funds are few when compared to those that do not maintain such a mandate. As with any type of investment, there can be no assurance that investment in ESG securities or funds will be profitable, or prove successful.

RiversEdge Advisors, LLC is a registered investment adviser.  Registration does not imply a certain level of skill or training. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.