Over the past 20 years, companies have become more focused on environmental, social and governance criteria in the management of their own businesses as a result of changes in the global regulatory framework, Zachary Karabell, head of global strategy of Envestnet, said Wednesday on a webinar.
However, these issues have been “funneling in and out” of investors’ and corporate managers’ priorities for about 40 years, he said.
Still, “in the investing world in general, particularly in the United States, there’s still some ambivalence about impact [investing],” he said, and about whether a company’s environmental footprint, corporate governance, and relationships with workers and communities are worth incorporating “into portfolio construction in the belief that there is a tension, and a negative tension, between those criteria and financial performance.”
That tension stems from beliefs that took hold in the 1970s, Karabell said, that capitalism wasn’t a constructive force. Concerns about ecological damage, pollution and the “negative consequences of capitalist growth” led to a “countercultural reaction against capitalism that became the first iteration of what we would now call ESG or SRI investing,” he said.
Religious institutions were already using negative screens to exclude companies in morally objectionable sectors in their portfolios, thereby “removing companies that might be generating positive return, and often those negative screens did lead to some underperformance,” which contributed to the idea that ESG investing required investors to sacrifice returns.
A new wave in the 1990s, particularly in Europe, developed a “more embedded belief in investing for the sustainable future,” Karabell said. That meant investing in companies that were looking not just at quarterly performance, but long-term sustainable growth, he noted.
In the last 10 years, the criteria used to analyze companies for ESG investing has become “much more dynamic, much more fluid [and] much more embedded with very traditional, rigorous financial analysis.”
However, Karabell noted “there’s still a real disconnect between what a lot of people and institutions want and what a lot of advisors and third parties want.”
Millennials and women are driving the interest in impact investing, Karabell said. Millennials’ interest is “mostly aspirational,” Karabell said, but for women it’s very real. “Women are controlling ever larger portions of investable assets at an individual level,” he said. “There’s a real trend where women in particular express their desire that their investments both do good and do well.”
The tools used for impact investing have evolved, too, Karabell said, and more rapidly than skeptics believe. “We’re not in a world where you can only use negative screens.” In today’s business world, especially among multinational companies, “it’s not a question of should you attend to these issues, it’s a question of how.”
The U.N. Global Reporting Initiative demands that companies report on ESG criteria like environmental impact, employee retention and corporate governance, Karabell said.
“All of these issues that seem to have this externality to financial performance are actually intimately connected to it,” he said. “If you’re seen as a higher credit risk because of variable costs you can’t control, and too-high levels of debt, that’s a negative. If you’re seen as having a strong buy-in to your local community, where you have strong employee retention and you’re managing costs, that’s always going to be good for your credit rating. It’s going to lower your cost of capital. It’s going to potentially be a positive for your return on capital and for shareholders, their return on investment.”
Karabell said that research from Envestnet and others has shown that at worst, impact criteria may have a neutral effect rather than negative. There is even some evidence that ESG investments provide some downside protection, possibly because “companies that are invested in these criteria have better bond ratings or better management, are less volatile, are less beta-ish.”
He noted, though, that clean energy companies have been “unbelievable correlated to the price of oil and very beta-heavy.”
“Increasingly, there is a fiduciary responsibility to integrate these issues and a return responsibility,” Karabell said. Almost two-thirds of advisors agreed they have a fiduciary responsibility to incorporate ESG factors, according to a 2014 US SIF survey.
Impact investing has shown “incredible growth,” Karabell said, and he believes that will continue until it’s no longer a niche or specialized strategy.
“At best, in 10 years we won’t be having these conversations because these questions and these variables will be factored in to portfolio construction as a matter of course, just as margins and earnings and valuations and return on capital are factored in to portfolio construction,” he said.
The webcast was presented by RIA Channel, which produces investment webinars for financial professionals.
In another session, Nikki Gwilliam-Beeharee, head of ESG Research of Vigeo Eiris, explained how to use ESG research to develop clients’ portfolios.
She recommended advisors start by examining the level of control and type of investments their clients currently have, including which strategies are active or passive, and the universe each issuer operates in.
Then they should define their own ESG investment policy to guide clients’ approach. “The policy for the investment can certainly vary depending on the different beliefs and investment decisions, the approach that each investor wants to take,” Gwilliam-Beeharee said.
Monitoring the issuer’s progress is critical as regulations and market conditions change to affect their ability to meet their ESG mandates. “Different events happen, as well as different exposure or legislation that could impact the ESG performance of different issuers.”
Viseo Eiris believes firms with a social responsibility focus can mitigate risk and provide sustainable performance for investors. “The idea here is to have a managerial approach, and to bring through that risk and opportunity analysis per company,” Gwilliam-Beeharee said.
Viseo Eiris doesn’t make ethical judgments about companies, but looks at international references, such as those from the International Labor Organization or the Organization for Economic Cooperation and Development, as a benchmark to judge how well they meet ESG criteria.
As for which themes are gaining popularity among investors, Gwilliam-Beeharee noted that tobacco has become increasingly more popular as a negative screen. Companies’ carbon footprints and energy transitions are another hot topic for investors. Gwilliam-Beeharee pointed out that investors need to look at a company’s current carbon footprint as well as any plans to transition into cleaner or renewable energy sources.
Divestment isn’t the only option for investors who want to unload companies with too much exposure to certain themes. For example, she said, some coal companies are making efforts to adopt renewable energy practices. Investors who used a negative screen to avoid those firms entirely could miss out on good opportunities. This highlights the importance of examining not just a company’s carbon footprint, which looks at the past, but its transition to lower impact energy output.
— Read How Socially Responsible Investing Strategies Are Built: A Case Study on ThinkAdvisor.