At the recent Davos Economic Forum in Switzerland (January 21-24, 2020), the world’s business, political, social, and wealth elites met to discuss the state of the world economy and challenges to global growth and sustainability. The area of interest receiving the most attention was how governments, corporations, and investors should responsibly act to address global climate change and environmental sustainability. More recently, interest has also increased regarding the efficacy of using investment policy as a tool to address public health and social justice concerns.
This is not a new issue for investors. Environmental, Social, and Governance (ESG) investment strategies and products have proliferated in the past five years. This is due to individual and institutional investors becoming increasingly interested in positioning their portfolios as forces for good in the world while still achieving long-term asset growth and income.
Socially Responsible Investing (SRI), of which ESG is a type, gained public notoriety in the late 1980’s. The divestment movement against South Africa’s apartheid government saw more than 150 college endowments, along with many state and local pension funds, sell all their stocks of companies deemed to be profiting from or supporting the South African policy. This had the further result of seeing “over 200 US companies cut all ties with South Africa, resulting in a loss of $1 billion in direct American investment.”1 The resulting capital flight created intense economic pressure on the country, which eventually brought an end to apartheid and lead to the historic election of Nelson Mandela in 1994.
In today’s vocabulary, this kind of ESG investing is classified as “screening.” An investor chooses to have companies and/or countries who violate certain norms expressly excluded from their portfolio.
In a research paper by investment management firm AQR, in conjunction with the United Nations Principles for Responsible Investment, the authors describe the range of approaches investors may take in expressing their ESG convictions through portfolio construction.2
Responsible Asset Selection
Responsible Asset Selection helps determine which assets should be held in the portfolio. Screening is usually thought of as exclusionary. For instance, an investor opposed to smoking and tobacco might exclude Phillip Morris. Positive screens focus on inclusion and identify which companies should be held. In the case of an investor whose governance goals include favoring companies with female Board members or Executives, a positive screen would identify which companies met these criteria and would, therefore, be included in the portfolio.
ESG Integration seeks to understand the additional risk and return characteristics of companies and countries with positive and negative ESG qualities. Current research indicates that good governance, e.g., companies with strong shareholder rights, favorable working conditions, etc., may have better long-term expected returns than poor governance companies.
Responsible Ownership
Investors may also focus on Responsible Ownership, doing things that positively influence the direction of the company as a shareholder. Rather than negative screening and completely divesting from the company, a responsible owner will actively vote their proxies for board candidates who will champion favorable ESG policies within the company. The Responsible Owner maintains a “seat at the table” and engages company leadership through his or her voting rights.
ESG investing is growing in popularity and public interest. The values being expressed through ESG related portfolio decisions are as diverse as the universe of investors participating in global markets today. Additionally, statistical conclusions as to the potential costs or benefits, either in expected risk or return of making these kinds of investment decisions, are unclear and being widely studied by academics and investment companies.
Anecdotally, during the first four months of 2020 and the COVID-19 crisis, more than 70% of ESG funds outperformed their non-ESG counterparts within similar asset classes.3 These funds selection criteria reduced their exposures to the energy sector, which declined due to falling oil prices. At the same time, they increased their exposures to technology companies, which generally have employment policies favored by governance criteria and whose business models performed well in the stay-at-home, work-from-home economy which began in March of 2020.
As a fiduciary, Foster Group has taken steps to develop portfolio construction options which enable investors to pursue Responsible Asset Selection and Responsible Ownership according to their unique values and convictions. If this is an area of interest for you or your organization, we would welcome a discussion of your unique goals and what investment approaches are available.
1. https://www.investopedia.com/articles/economics/08/protest-divestment-south-africa.asp
2. “Responsible Asset Selection: ESG in Portfolio Decisions,” AQR Alternative Thinking, Q4 2019
3. “ESG Investing Shines in Market Turmoil, With Help From Big Tech,” Wall Street Journal, May 12, 2020