Investing For a Better World
Oh, the irony! Just as major corporations are pulling back from initiatives to increase diversity, equity and inclusion in their workplaces and some investment firms are speaking about environmental sustainability only sotto voce, in my practice I am only seeing an increase in interest in making investment choices in line with these values.
Let’s start by defining our main acronym. ESG = environment, social and governance. An ESG fund is a fund that invests in companies that aim to not harm the environment (the E), demonstrate practices in their management that, just as an example, contribute to a more inclusionary workplace and respect for human rights (the S covers a lot of ground), and govern themselves as a corporation in an ethical manner (the G). (You may also hear the acronym SRI, Socially Responsible Investing.) That’s an oversimplification I know, and I encourage you to learn more here, but let’s go with it for now.
Your starting point in ESG investing is actually not poring over reports of corporate behavior. Rather, begin by identifying what is important to you. What are the practices or types of industries that you absolutely would not want your dollars to support? Common industry “no go’s” are private prisons, weapons manufacture, tobacco, fossil fuels. Are there specific companies that are a hard no for you? (Starts with a “T” ??) Everyone’s list is a little bit different. On your own inventory, what values are absolutes for you and which ones might you be willing to compromise on? You will need to be clear on that as we proceed.
I am going to make a leap here and assume that you are passingly familiar with active versus index mutual funds (and ETFs). That is, you understand that funds can fall into two very broad camps: passive index funds that are automatically invested in a large number of companies, all of which are represented in a broad market index (such as the S&P 500), and actively managed funds, where the selection of companies in the fund is chosen by a human fund manager.
And so it is with ESG funds. You can choose an index ESG fund or an actively managed one. How do you decide? Well, think back to your starting point when you identified what specific values were important to you.
Just as there are many “regular” indexes that a mutual fund could be tied to (the aforementioned S&P 500, the Russell 2000, etc.), there are several ESG indexes that ESG index funds could follow. Principally, there are the MSCI and FTSE family of indexes. The detailed construction of their indexes is a bit out of scope for this simple blog post, but here is the main point: While they can be similar, they are not identical. Just as an example, the MSCI USA ESG Leaders index only excludes fossil fuel companies that are involved in unconventional extraction, such as from oil sands; the FTSE USA index excludes all fossil fuel companies. And so ESG index funds that are designed around these two different indexes look different. Which is better? Well, it goes back to your values and preferences. Some people are supportive of investing in fossil fuel companies if they feel they are committed to transitioning to green sources of energy; other people would prefer to avoid the sector entirely. What is and is not ESG is very much in the eye of the beholder. Some people think that is a problem, but I don’t.
Index ESG funds are an example of an exclusionary approach to ESG investing. Imagine your starting point as every publicly traded company in the world and then strain out the “bad guys.” What’s left is your ESG fund.
You could also take a more active approach, narrowing your investment to just the companies that score the highest on ESG metrics, and engaging with the management of these “good” companies to move them to even better practices through stakeholder activism. This is the approach of actively managed ESG funds. Instead of buying a bit of every company represented in an ESG index, these fund managers curate a much more limited set of companies in which to invest. Obviously, this comes with a cost and so an actively managed ESG fund will carry a much higher expense ratio than an ESG index fund. But getting back to your values, this may be the approach that speaks to what you want to accomplish with your investment portfolio.
There is more — much, much more — to be said about ESG investing, so consider this to be merely a light introduction. Do ESG funds have similar market returns as traditional funds? Can ESG ratings be trusted, or do companies “greenwash” to score higher? What are the non-equity market ways of investing ESG-style? Really, I could write a book. (Perhaps I will.)
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