SRI, ESG and Impact Investing: What Advisors Should Know

Last month brought one of the most seismic shifts in capitalism’s history when nearly 200 CEOs of America’s largest companies, collectively known as the “Business Roundtable,” agreed to redefine the central purpose of the corporation. No longer, the Business Roundtable declared, will the focus of the corporation be to maximize shareholder profits at any expense. Rather, the new central purpose of the corporation is to focus on delivering value to multiple social stakeholders — including employees, consumers and communities.

What does this all mean, and why should advisors care? Because this new wave of social responsibility has come to Wall Street, not by way of regulators or politicians, but from the most unlikely source: our clients, the millions of everyday investors who, through the allocation of their retirement savings, are now applying bone-crushing pressure to the world’s largest and most powerful multinationals to clean up their act.

This trend is fueled by three developments. First, today’s investors are more educated and better informed than at any time in history, which has led to a growing awareness of both the plethora and seriousness of the issues confronting society. In the age of social media, companies who commit environmental atrocities or engage in abusive labor practices can be mercilessly punished by consumers (via boycotts that hurt revenue) and investors (who drive up the cost of capital for offenders).

Second, there is growing consensus that government action by itself a necessary but in insufficient solution to some of society’s most pressing challenges, such as climate change and social inequality.

Finally, seismic demographic and economic shifts have brought more women and millennials, who generally tend to be more socially conscious investors, into global capital markets.

SRI, ESG & Impact: What’s in a Name?

Don’t be confused. The key word is “investing”; this is not about philanthropy. Regardless of the label, all of these approaches are ultimately about seeking a positive financial return while bringing about positive change in some way.

Socially Responsible Investing (SRI)

Socially responsible investing typically refers to constructing portfolios using “negative screens” to exclude firms or sectors involved in activities investors deem to be unacceptable or controversial. For example, this might include building a portfolio that excludes firms that sell weapons or tobacco or firms with egregious environmental or human-rights records. Investors utilizing an SRI approach to portfolio construction essentially “punish” bad actors by denying them use of their capital.

Environmental, Social & Governance Investing (ESG)

ESG investing, while related to SRI, is materially different. ESG investing focuses on investing in companies with high environmental, social and governance scores relative to their peers.  Subsequently, ESG investing doesn’t necessarily exclude “bad actors”; it focuses on firms with high sustainability ratings relative to their peers.

It’s an approach that subsequently focuses on “best-in-class” firms but doesn’t explicitly exclude any firm or industry. For example, a tobacco company might receive a high ESG score for having a diverse board and sustainable agricultural practices even though they’re in the business of selling tobacco. In this way, ESG investing “rewards” best-in-class actors by providing them exclusive use of investors’ capital.

Impact Investing

Impact investing takes SRI and ESG investing further in that it explicitly focuses on solving specific social or environmental problems. It does this in two ways. First, impact investing explicitly focuses on those companies with the best ESG scores; second, it typically excludes companies engaged in undesirable activities.

Subsequently, impact investing is essentially a hybrid that borrows from both SRI and ESG investing approaches. Similar to ESG investors, Impact investors “reward” those companies making the most powerful impact on solving specific social or environmental problems. They do this by providing their capital exclusively to such companies.

Strategy Underperformance?

Modern Portfolio Theory suggests that limiting the investing universe results in the construction of a less risk-efficient portfolio. Subsequently, conventional wisdom for many decades held that socially responsible approaches to portfolio construction resulted in lower returns to investors. However, there is now a considerable amount of academic evidence that proves socially responsible investing — in all its forms —does not reduce performance.

There’s even some real-world evidence that ESG and impact investing can result in outperformance. The MSCI KLD 400 Social Index is an index of 400 U.S. companies with high ESG ratings and excludes companies whose products have negative social or environmental impacts. Since its inception on May 31, 1990, the index had an annualized return of 10.50% versus 10.08% for the S&P 500 Index (per FactSet Inc.), suggesting that a systematic approach to ESG investing may offer the potential for slight long-term outperformance.

Clients increasingly demand that their portfolio managers take ESG issues into consideration when building portfolios. Advisors would do well to get up to speed on ESG-related terminology and understand the impact ESG mandates might have, if any, on portfolio returns.

While the terminology often can sound redudant or confusing, all SRI, ESG or impact related strategies seek positive financial returns for clients; these strategies are not philanthropy. What separates one from another is the relative degree of activism they incorporate into the security selection process. Finally, evidence suggests ESG mandates do not, contrary to popular belief, hurt portfolio returns.

Donald Calcagni is chief investment officer of Mercer Advisors.