You have probably heard of ESG investing. ESG stands for Environment, Social, and Governance. While it is talked about more frequently these days, the concept is not new for Wall Street. The movement started in the 1970s and was called Socially Responsible Investing. The initial concept involved investors avoiding positions in companies that were involved in controversial businesses or practices, for example, certain investors wished to avoid investing in tobacco or gun manufacturers. In the early aughts, investors shifted focus from simply excluding companies to actually investing in companies that would have positive long-term impact. That movement continued to evolve over the next decade with standards bodies defining how corporations would track and report their ESG activities. In the current decade, ESG has taken on broader acceptance and ESG investment frameworks have been adopted by regulatory bodies tasked with policing climate and sustainability efforts. ESG has shifted from niche investing to more mainstream investing where investors have many more options if they wish to participate in the investing style. Going forward, as Generation Z and Millennials become “of investment age,” it is expected that ESG investing will be fully mainstreamed. Let’s look into ESG, what it is, and how to participate in ESG investing.
ESG investing goes beyond traditional financial analysis and incorporates non-financial factors into investment decision-making.
Today, ESG Investors utilize a combination of strategies to integrate ESG considerations into their investment decisions. Integration involves incorporating ESG factors into traditional financial analysis, allowing investors to assess the risks and opportunities associated with a company's sustainability practices. ESG-themed investing focuses on specific environmental or social themes, such as renewable energy or gender equality, and selects investments accordingly. Exclusionary screening involves rejecting companies engaged in controversial activities, such as tobacco or weapons production, or more broadly hydrocarbon reliance. Lastly, impact investing should generate measurable positive social or environmental impact alongside financial returns.
Measuring ESG performance is crucial for investors to assess the sustainability practices of companies. ESG ratings agencies, such as well-known MSCI provide scores that enable investors to compare different companies within similar industries. Additionally, frameworks like the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB) provide standards for companies to disclose ESG information and facilitate transparency.
ESG investing also goes beyond financial returns by addressing societal and environmental challenges. By actively investing in companies with positive ESG practices, investors can contribute to the achievement of sustainability goals, such as combating climate change, promoting diversity and inclusion, and fostering responsible governance. This proactive approach not only generates tangible impact but also aligns investment portfolios with investors' values and principles. You are probably thinking, “Mark, this is Wall Street where everything is measured on financial success or… um, lack of success, so what gives?” That is, in fact, one of the biggest challenges with ESG investing. It is understandable that all of us want to make investments that have positive ESG impacts, but what are we willing to give up in return for that? Are we willing to give up anything at all? Finally, even if we are willing to give something up to have positive impact, what exactly are we giving up? Before I comment further, it is important to recognize that many ESG investment can and will have positive financial impacts, though they are usually in the longer-term… beyond the horizon of many analysts’ earnings models. Think of sustainable energy investments that require steep upfront investments but will not break-even or begin to overtake traditional energy for years to come, though they surely will… in the long run. The famous economist John Maynard Keynes once quipped that “in the long run, we are all dead.”
There is a broadly accepted framework for ESG investing called Social Return on Investment (SROI). In a nutshell the framework involves the following:
As implies above, the Measurement and Valuation components are where things get challenging and require a great deal of unrooted assumptions. But assuming, those assumptions can be made with confidence, the Impact Calculation is calculated as follows:
SROI = Value of Outcomes / Investment
You will immediately recognize that formula as the Return on Investment (ROI) calculation which has been repurposed to include social impacts, etc. Unfortunately, we are back where we started. There is no real mainstream way for us to solidly assess the financial value of an impact investment.
Impact investing, at its core, seeks to generate measurable and beneficial social or environmental impacts alongside financial returns. It involves deploying capital to address pressing global challenges, such as climate change, poverty, inequality, and access to healthcare and education. Impact investors aim to align their investments with their values and actively contribute to creating a more equitable and sustainable world. That said, ESG investing is still highly valuable, and an increasing number of investors are choosing to know more about the habits of their investments. If you are interested in Impact Investing and ESG there is some good news. Due to its rising popularity, there are countless PhD and doctoral candidates seeking to find better methods for valuation. If you are interested in making ESG investments, there are plenty of ETFs (exchange traded funds) which concentrate on it. Here are some examples:
SDG - iShares MSCI Global Impact ETF. Tracks the performance of the MSCI ACWI Sustainable Impact Index, which is focused on the United Nations Sustainable Development Goals (SDGs).
EFIV - SPDR S&P 500 ESG ETF. Tracks the performance of the S&P 500 ESG Index, which comprises companies from the S&P 500 Index that meet certain ESG criteria. It integrates ESG factors into the stock selection process, allowing investors to align their investments with sustainability principles.
ESGV - Vanguard ESG U.S. Stock ETF. Attempts to replicate the performance of the FTSE US All Cap Choice Index, which includes U.S. companies with strong ESG practices. It excludes companies involved in controversial activities such as weapons, tobacco, and thermal coal.
There are plenty of others, but it is important to remember that these are like any other investment which require careful consideration and diligence before investing.
Impact investing has the potential to reshape the financial landscape and redefine success in the 21st century. By leveraging capital for positive social and environmental outcomes, it can drive meaningful change and contribute to a more sustainable and equitable future. As the demand for impact investing grows, so too does the need for the acceptance of a robust financial valuation framework that will allow ESG and impact investing to be integrated into the broadly accepted valuation models that dominate the investment climate. I will leave you with one simple chart today which compares the S&P500 Index to the S&P 500 ESG Index performance over the past 10 years. You will see that their performance is close, possibly closer than you would have expected.