“ESG” has reached the status of buzzword at Wharton, thanks in part to its recent adoption by major investment banks and asset managers. Goldman Sachs, BlackRock, and Deutsche Bank, among others, are now dedicating significant resources to ESG. But what exactly is ESG? How does it add value to investments? And more importantly, how can you incorporate ESG into your personal portfolio?
What is ESG?
ESG stands for “Environmental, Social and Governance” and refers to the incorporation of these factors into investment analysis, policy or management. It is important to distinguish ESG-based investing from “socially responsible investing,” which centers on applying negative screens to “sin stocks.” In contrast, ESG-based investing is about integrating a comprehensive set of non-financial indicators into the investment analysis. One such indicator is carbon emissions—an environmental cost (“E”) and potential financial cost as regulations evolve; another example is employee turnover rate, which is not only a proxy for employee satisfaction (“S”) but is also a critical cost driver for companies. Although for some ESG is an ethical approach, for many it is about using a broader set of data to gain an investing edge.
How can it add value to investments?
An ESG approach adds value to investments primarily in two ways. Firstly, it enables investors to do more with their money—allowing them to make a social or environmental impact beyond the financial return. Secondly, it enhances the assessment of risk-adjusted returns. Many investors are now questioning the validity of Modern Portfolio Theory in light of the 2008 financial crisis and its aftermath. While Modern Portfolio Theory defines risk as simply the volatility of returns, it is also important to consider a broader concept of risk that includes systemic correlations, a greater frequency of tail events and the limitations of rating agencies. Furthermore, as the world population climbs past 7 billion and carbon emissions lead to climate disruptions, sustainability issues are increasingly putting companies’ operations at risk. In this uncertain environment, ESG allows us to capture un-priced systemic risks, long-term trends and intangibles in a meaningful way. In turn, this enhances our understanding of the portfolio’s beta and potentially provides additional alpha through an informational edge.
How can you incorporate ESG into your personal portfolio?
For the Stock Picker
For those who prefer to build your own stock portfolios, you can analyze ESG factors as part of the valuation process. Once you have a target company, identify what ESG factors are the most material for that particular business or industry. For instance, for the Food and Beverage Industry water management is arguably a more significant value driver than labor relations. With an initial roadmap of the relevant ESG factors, you can then search for ESG data. Aside from the company’s integrated reports, Bloomberg, MSCI and Reuters provide extensive ESG data. Next time you are at a Bloomberg terminal, type in “ESG <GO>” to get started. The goal of analyzing material ESG data is to decide whether the company should be considered “best-in-class,” or “in need of improvement,” or simply a subpar ESG manager. “Best-in-class” companies are typically those that set ESG policies, reach quantifiable targets and perform well in ESG-related situations. As a result they reduce their overall risk. If the financial analysis of the company is also compelling, then it is most likely a “buy.” The second category relates to companies that may have a strong ESG record in some areas but not in others. This does not mean that investors shouldn’t buy the stock, but rather that they should consider engaging with the company on ESG issues to push for a change in corporate practices. Shareholder activism can take the form of proxy voting, writing letters to the board, etc. The third category of companies should obviously be avoided, or even shorted, as the market price most likely does not adequately compensate for the ESG risks.
For the Autopilot Equity Investor
If you prefer to outsource investment analysis to asset managers, there are many ESG-based mutual funds available to retail investors. Although the conventional players, such as BlackRock and Goldman Sachs Asset Management, are only just starting to launch funds, many dedicated ESG shops offer funds with strong track records. For instance, Portfolio 21 is a global equity mutual fund (PORTX) that invests in companies designing environmentally superior products, using renewable energy, and developing efficient production methods. Another well-known player is Parnassus Investments. In a recent study by TruCost of conventional versus responsible investment funds, the Parnassus Equity Income Fund (PRBLX) came out on top in terms of alpha generation. Lastly, PAX World Funds recently launched a set of ESG Exchange Traded Funds that passively track MSCI’s ESG indices (NASI, EAPS). This is in addition to their actively managed funds, such as the Pax World Global Women’s Equality Fund (PXWEX).
For the Diversified Fixed Income Investor
ESG analysis also applies to fixed income markets. The most obvious application is to corporate bonds, with the only significant difference being that bondholders cannot as easily engage with companies on ESG issues as shareholders. In the case of sovereign bonds, governments can be evaluated on ESG criteria. The municipal bond market is a surprising source of “best-in-class” ESG bonds due to the fact that states often use them to finance ESG-related projects. For example, Florida recently issued “Everglades Restoration Bonds” to finance its conservation efforts—these bonds not only provide attractive returns, but also make an environmental impact. If you prefer buying funds to over-the-counter purchases, there are several ESG-oriented providers, such as Dexia Asset Management (ex. DEXWORD:BB), Domini Social Investments (ex. DSBFX) and Calvert Investments (ex. CSIBX). TriLinc Global also recently launched a retail fund that invests in debt of Small and Medium Enterprises in developing countries, again providing financial return with the potential for social impact.
ESG is a tool that investors from the individual to the institutional level can apply across asset classes. By formally incorporating external factors that will increasingly impact a firm’s return, ESG should help us to not only prepare for the challenging macroeconomic environment ahead, but also to use our capital to make a social and environmental impact along with financial returns.
To learn more, please join us at the Social Impact Conference this Friday, February 3rd in Huntsman Hall.