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How to Discuss SRI, ESG and Impact Investing With Your Clients

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What You Need to Know

  • Advisors often hesitate to talk to clients about the subject.
  • Explaining the distinctions between terms should be an important aspect of the advisor-client dialogue.
  • The terms SRI and ESG are often used interchangeably but can be very different in application.

Sustainable and responsible investing is a polarizing topic. Although investor dollars are flowing to the many product offerings launched by fund companies, advisors often hesitate to talk to clients about the subject. Definitional confusion contributes to heated debates between proponents and skeptics.

Commonly used terms such as environmental, social and governance; socially responsible investing and impact investing mean different things to different people, with terms often twisted to fit a favored narrative.

Definitions Matter

Explaining the distinctions between terms should be an important aspect of the advisor-client dialogue. Exclusionary approaches, often described as SRI strategies, eliminate individual holdings or market sectors that investors wish to avoid. “Personalization” is an emerging description of strategies designed around personal preferences.

Commonly implemented exclusions include “sin stocks” such as alcohol, tobacco and gambling companies; climate-focused investors have embraced “fossil-fuel-free” strategies that exclude traditional energy and utility companies.

The terms SRI and ESG are often used interchangeably but can be very different in application. ESG considerations go beyond the purely exclusionary focus of SRI.

ESG investors believe that today’s nonfinancial considerations, such as carbon emissions, water use, labor practices, and regulatory/compliance track record, often become tomorrow’s material financial factors. Many ESG-focused investors integrate ESG analysis into research evaluating traditional financial metrics.

Impact investments are intended to generate a measurable and beneficial social or environmental impact alongside a financial return. Impact investors direct capital to companies seeking to solve some of the world’s greatest problems, such as climate change, income and wealth inequality, diversity, equity and inclusion.

Exclusionary Approaches

Harvard University is one of many universities that plan to phase out all investments tied to oil, gas and coal; Boston Mayor Michelle Wu’s first bill signing was an ordinance requiring the City of Boston to divest from fossil fuel, tobacco and private prison industries by the end of 2025.

Some investors divest to align their portfolios with personal values; others cite economic reasons including the risk that conventional fossil fuel companies will be stock market losers given “stranded assets” that will need to be left in the ground. Opponents of divestment challenge climate change assumptions or expect the transition from fossil fuels to renewables to take decades to unfold.

Fossil fuel divestment is a controversial topic. Fossil fuels represented more than 80% of primary energy consumption in 2019, with renewables (such as wind and solar) and other non-fossil fuels (such as nuclear) slightly above 15%.

Absent significant shifts in government policy or near-term breakthroughs in clean-energy technology, traditional and clean energy sectors may coexist for many years before the world can fully rely on alternative energy sources.

Wind and solar costs have fallen dramatically but continue to be intermittent sources of energy. For values-focused investors, issues related to the supply chain for batteries and manufacturing of alternative energy technologies may also raise questions around environmental impacts, potential resource constraints, labor practices and geopolitics.

Advisors should understand the trade-offs implicit in exclusionary approaches. Some of the commonly excluded industries are a relatively small part of the market, mitigating the potential opportunity cost of avoidance. For example, the energy sector is the best-performing S&P 500 sector year-to-date but now represents less than 3% of the S&P 500 Index.

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In contrast, more than 20% of companies in the S&P 500 are exposed to animal testing, so a blanket avoidance of animal testing would have a consequential impact on the investment opportunity set.

ESG Considerations

SRI and ESG integration strategies may differ in material ways. SRI strategies typically avoid certain industries and companies regardless of price; ESG integration strategies may find a price at which a company would be an appealing investment despite ESG risks.

For example, a fossil-fuel-free strategy may explicitly exclude Exxon or Chevron stock, but an ESG integration strategy might own one or both stocks if the price was attractive enough to offset ESG risk considerations. In addition, some ESG investors may distinguish between traditional energy companies that can successfully contribute positively to a net-zero world and those less able or willing to adapt.

ESG ratings provided by MSCI, Morningstar and others are often compared unfavorably with credit ratings, as ESG ratings exhibit a far lower correlation than credit ratings. The comparison between ESG and credit ratings may not be an appropriate comparison.

Just as there isn’t universal agreement about the valuation of a company, there may not be universal agreement about the ESG merits of a company. A company that gets high marks from one rating firm may get dramatically different ratings from another, for perfectly legitimate reasons.

Few companies are universally “good” or universally “bad.” Tesla is a favorite of many environmentally focused investors for its leadership in the transition to a lower-carbon world. Social and governance-focused investors may be less enthusiastic about Tesla given shortcomings in the firm’s governance structure, Elon Musk’s battles with regulators, and labor relations that have not always prioritized worker safety.

The ESG merits of leading technology companies is another area of potential disagreement among ESG investors given different but defensible assessments about issues such as privacy, supply chains, labor conditions and antitrust.

Impact Investment

ESG investors focus on how companies go about doing what they do; impact investors focus more on what they do. Among the problems addressed by impact investors are poverty, hunger, education, inequality, clean water and sanitation, clean energy and climate action. The United Nations Sustainable Development Goals and targets reveal many areas of potential impact.

The highest impact opportunities may be with companies trying to solve some critical problem that would otherwise be left unaddressed. Companies with a material focus on one or more of these targets would meet the impact definition; impact-focused investors assess whether the company’s core business is authentically creating impact.

Companies that make furniture or sell software in a sustainable way may meet the aspirations of SRI or ESG investors but often fall short of impact targeted by impact-focused investors.

Conclusion

Advisors play a vital role in providing education, helping clients decide what approach or combination of approaches best aligns with the client’s preferences. Some clients may prefer the values-alignment provided by an SRI approach; ESG or impact-oriented strategies may resonate more with other clients.

Another key role for the advisor is to look beyond marketing hype to assess the authenticity of an SRI, ESG or impact offering. In many cases, particularly with the proliferation of thematic products, the product offering may have more style than substance. Ultimately, a well-informed client is more likely to remain a satisfied client.


Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston. Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds. Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the board of trustees for the Green Century Funds.