Over recent years, the notion of social and environmental responsibility in investing has taken on unique importance. Of course, people invest money to grow their wealth, but this is no longer enough in a world that’s become increasingly aware of the difference individuals can make, particularly with their money.
This goal of creating financial returns as well as a positive social impact has become a sub-industry in and of itself: socially responsible investing or ESG investing. At Moneyfarm, we’ve gone to great lengths to give our own socially responsible investment product the best chance of achieving both goals, while being adaptable to our investors’ personal objectives and attitudes.
The main questions we hear when we discuss socially responsible investing are simple: how to SRI investing work, and how do the portfolios perform? The short answer is that they generally perform comparably to regular portfolios, while in many cases, they outperform. The full answer is a little more complex – we’ll explore it in detail here.
How does socially responsible investing work?
Socially responsible investments consider environmental, social and governance ESG criteria. These criteria help some socially responsible investors decide which corporations to invest in. Basically, socially responsible investing is a type of investing that involves negative screening by avoiding industries that negatively affect the environment and its people, including fossil fuels, alcohol, tobacco, gambling, and weapons.
Socially responsible investing is also known as ethical investing or green investing and includes investing in companies and businesses that support human rights, environmental sustainability, community development, health care, education, and other causes.
Investors also consider SRI investing to mean sustainable, responsible and impact investments. Regardless of your preferred definitions, socially responsible investing works towards positive change and financial gains.
Socially responsible investors tend to follow political and social issues, and they can positively impact their society and environment via an investing strategy that includes ESG funds made up of individual stocks, mutual funds and ETFs.
Things to consider with socially responsible investing
Let’s a step away from the impact investing for a moment. There are several other things to consider when opening a socially responsible portfolio. The decision comes with myriad pros and cons to be aware of.
For example, by definition, socially responsible investing means limiting the pool of businesses you invest in. Whether you choose to exclude businesses with questionable morale practices or reward those going the extra mile, the end result is a necessary reduction in the number of available options. This isn’t necessarily a problem, but it’s something for wealth and fund managers and investors to consider.
On the flipside, socially responsible investing opens you up to opportunities you might otherwise miss with a regular portfolio. For example, there is plenty of literature and analysis to support the idea that businesses that focus on ESG criteria will be protected from many long term issues going forward, like climate change.
We’ll go into the positives of ESG investing later in the article, but the important thing to note is that every investment strategy has pros and cons. Wherever you find limitations, there are likely to be equal opportunities to balance them out.
How does performance compare?
So, let’s turn our attention to performance. Here’s where matters become a little more complicated. It would be great if we could say conclusively that selecting and investing in companies based on ESG criteria always gives you better returns.
Unfortunately, the evidence is not so clear-cut.
If we look at the meta-research around ESG performance, most of it shows that socially responsible investing can lead to positive performance. The evidence shows that a focus on environmental, social and governance concerns doesn’t necessarily hinder performance, and in many cases, the opposite is true.
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The results of over 2,000 studies on the impact of ESG on equity returns found that 63% of cases were positive, while only 8% of the findings were negative*. Of course, none of this tells us a huge amount about the future performance of socially responsible investments, but what we can say is that we don’t expect focusing on ESG criteria to be any significant drag on performance.
However, we should consider that socially responsible investing SRI includes a wide and diverse range of products and that their construction can vary and their performance can differ. Secondly, it can be difficult to fully discern the impact of ESG on returns relative to other factors, like quality. Finally, the composition of ESG investments and their exposure to different systematic risks can also affect returns.
If we look at the main global indexes, the short answer is that, historically, sometimes you’d have done better, sometimes worse – often depending on the index you choose and how well commodity prices have performed.
The chart below illustrates the point. It shows the performance of various Global ESG indices compared to the underlying standard index. While the overall performance for ESG has been positive, much of that has come over since late 2018. The relative performance over previous years has been mixed.
How ESG can benefit individual businesses
It’s important to bear in mind when talking about the impact of ESG on businesses, that business performance is just one of several components that affect financial returns. The risk premium the investee pays to the investor is another crucial factor, for example, which can be higher for non-ESG companies.
There are some advantages that companies with less ESG risk will have from a financial point of view. McKinsey & Company identified five important ways in which ESG links to cash flows. These are:
Businesses with a strong social and environmental image are fundamentally more attractive propositions. For both B2B and B2C companies, a positive social image will be attractive to customers – on the flipside, association with unsustainable or unsafe business practices can take a demonstrable toll on how a company is perceived.
On an internal level, businesses with a strong ESG proposition will lower their energy consumption, water intake, and waste. But unfortunately, the opposite side of that coin is higher waste disposal costs and spending more on energy.
Regulatory and legal interventions
This is a factor that will only become more important as time goes on. By adopting less stringently regulated business practices, organisations can operate with far more freedom and enjoy a symbiotic relationship with regulatory bodies and governments. Companies that fail to do so risk suffering restrictions on advertising and point of sale, while fines and penalties incurred could have a significant impact on a business’s bottom line.
Broadly, people want to work for businesses they feel are making a positive social and environmental impact. Though difficult to quantify, the talent acquisition perks enjoyed by ESG-focused businesses can be huge. This is particularly evident when you consider the opposite side of the argument – businesses with ‘social stigma’ can find it tough to attract the right talent.
Investment and asset optimisation
A socially responsible mindset can help businesses enhance investment returns by better allocating capital for the long term, for example, more sustainable property and equipment. By looking to the future, companies can avoid creating stranded assets that arise as a result of premature ‘write-downs’ and save money relative to their more energy-reliant competitors.
This article is simply a snapshot of the considerations our team of asset allocation specialists have had to make while constructing our socially responsible portfolios. For more information about how you could benefit from an ESG portfolio, take a look at our comprehensive page. If you want to discuss a potential portfolio in more detail, feel free to book a call with a member of our investment consultancy team, who will be happy to talk you through your options.
*Source: Gunnar Friede et al., “ESG and financial performance: aggregated evidence from more than 2000 empirical studies”, Journal Of Sustainable Finance & Investment, October 2015, Volume 5, Number 4, pp. 210-33; Deutsche Asset & Wealth Management Investment; McKinsey analysis