light bulb (Image: Shutterstock) (Image: Shutterstock)

Sustainable investing, an investment approach that incorporates environmental, social and governance (ESG) factors, is a rapidly growing but often misunderstood investment strategy. Although many investors downplay the relevance of ESG considerations, my experience as a board member of a sustainable mutual fund family has taught me valuable lessons that are relevant beyond the world of sustainable investing.

Lesson 1: Nonfinancial factors provide signals about future financial performance. ESG considerations can provide an early warning about risks that are not immediately reflected in financial statements or stock prices — just look at Wells Fargo, Facebook, Equifax, BP and PG&E. For example, complaints and litigation related to Wells Fargo’s business and employment practices were widespread long before the fake-account scandal became front-page news. Safety concerns were also an issue for PG&E prior to the San Bruno pipeline explosion and Northern California wildfires. ESG analysis isn’t only about identifying risks, as companies with strong ESG attributes may also provide strong stock market performance. For example, a growing body of academic research indicates that companies with two or more women on the board of directors tend to deliver stronger financial performance than companies that have less than two women on the board. It seems counterintuitive that “traditional” fundamental investors often downplay the importance of ESG considerations, considering how often fundamental stock analysts cite management quality as an important subjective consideration.

Lesson 2: Climate change is a disruptive force. Climate change is an important strategic planning consideration for an increasing number of companies. Many companies are deploying capital to take advantage of investment opportunities in renewable energy, electric cars and autonomous vehicles. Auto companies are making big financial bets on the future of electric cars, and utilities are adapting to a world in which renewable energy is cleaner and increasingly cost-competitive with fossil fuels. Companies are also increasingly taking steps to mitigate climate change risks. Wildfires in California seemingly are becoming an annual occurrence, a function of drought conditions and population sprawl. The insurance industry is changing underwriting models, pricing and contract terms to reflect what the industry considers to be the “new normal” for fire peril. Although debates about climate change often are framed in black and white ideological terms, capital deployment by corporate CEOs provides evidence of the significance of opportunities and risks associated with climate change.

Lesson 3: Determining the ESG merits of a company is far from easy. Distinguishing between “good” and “bad” companies from an ESG perspective may be every bit as subjective as determining the value of a company’s stock. A study from State Street Global Advisors identified major deviations in ESG ratings among major rating firms, highlighting that there isn’t necessarily a “universal truth” about a company that is reflected in ESG ratings. In addition, investors debate whether the “level” of ESG quality provides the strongest signal or whether trends in ESG quality provide a more relevant signal for future stock market performance. Some ESG investors resemble value investors in thinking that a lagging but improving company in ESG terms may be a better stock market performer than a top ESG performer that may be overvalued by the market.

Lesson 4: Shareholder advocacy can make a difference. Although sustainable investors are in most cases much smaller than the goliaths of the investment industry, some relatively small investors have had a material influence on corporate behavior. Deforestation, board diversity, food waste and carbon emissions are among the issues in which relatively small mutual fund firms have been leaders in negotiating major changes in corporate behavior.

Lesson 5: A fifth lesson is universal in nature: It is important to be a skeptical buyer. Sustainable investors aren’t immune from the temptation to make exaggerated or misleading claims. For example, excluding a limited number of stocks from a thoughtfully constructed portfolio may not have a meaningful impact on investment results. However, a recent presentation claimed that “you can divest from oil — or anything else — without much consequence.”

The presentation illustrated that from 1989 to 2017, performance results of the S&P 500 Index and a version of S&P 500 that excluded energy stocks were virtually indistinguishable from one another. Over the multi-decade investment time horizon typical for endowments and pension plans, performance differences over shorter-term periods offset one another. Unfortunately, many individual investors don’t have the financial luxury or the patience to ride out performance swings over a multi-decade time horizon. During much of the 2000s and in recent periods of strength for oil prices, S&P 500 Index portfolios that excluded energy would have meaningfully lagged the index. It pays to be skeptical of those who claim that exclusionary strategies are a “free lunch,” that there is a universal right and wrong when it comes to ESG, or that all you need is a portfolio exclusively invested in “good” companies from an ESG perspective in order to beat the market.

I had a mostly traditional perspective before I joined the board of a sustainable mutual fund company. My experience on the board has been eye-opening, and I think the lessons shared above are broadly applicable for investors. Integration of ESG factors, understanding of the disruptive force that is climate change, and awareness of the influence of informed shareholders on corporate behavior are all important lessons to be learned from sustainable investors. A healthy degree of skepticism may also be a recipe for investment success, a lesson than should never be forgotten.

— More by Daniel S. Kern on ThinkAdvisor: