Making a difference can grow your portfolio

Dismissed as a fad or flavor of the moment as recently as five years ago, the idea of incorporating an environmental, social, and governance lens in the investment process now looks here to stay.
Over the last 20 years, the social investing industry has grown and changed. It has moved from “negative screening,” such as divesting from South Africa or excluding “sin stocks” from a portfolio, to a more positive approach that favors good companies and can even improve companies through shareholder advocacy and lobbying.
ESG investing also has attracted more investors. According to the The Forum for Sustainable and Responsible Investment, ESG assets under management have grown 22 percent from 2010 through 2013 to $3.74 trillion. Since 1995, ESG assets have grown faster than professionally managed assets as a whole.
ESG is an information category just like any other. Relative to more traditional financial information, ESG factors can be overlooked more easily and not adequately understood. Thus, if someone has an advantage understanding potential risk factors, then I believe, all else equal, that person has an advantage in valuation assessment and portfolio risk management.
From academics to investment managers to watchdogs, people in all corners of the investment industry have begun including ESG as a genuine consideration. The change has had a large and fundamental impact on the financial markets.
ESG factors are now being used as part of competitive analysis and fundamental analysis. In turn, money managers are including these factors as data points that can help decide whether or not they buy the stock or a bond of a particular company. Looking at ESG trends can help investors find areas of growth, identify companies that are cutting costs by being more efficient, and avoid reputational and economic risks. For example, investors may notice that resource scarcity can create growth opportunities for companies with solutions to improve efficiency or replace fossil fuels. They may consider whether a company’s poor record on labor practices could result in costly disruptions from a strike or regulatory action, or a consumer boycott. They may question whether a board’s structure allows it to make the best decisions for all of the company’s stakeholders.
Many companies now provide an annual corporate sustainability report as part of their regular reporting package to investors and stakeholders. To cater to this new demand, accounting firms such as Ernst & Young and PricewaterhouseCoopers offer services to verify sustainability reporting. Now that the watchdogs have started to focus on these metrics, investors are more easily able to measure and compare companies on issues that were previously not considered. As more investors track these ESG factors and make decisions based on them, they become more material to stock and bond prices.
However, when an area gains popularity so quickly, there is always the chance that money managers will offer products just to profit from the trend, not out of a genuine belief in the approach. Unfortunately, we find that there are strategies out there today that are marketing themselves as environmentally friendly when in fact their ESG criteria are not very strict. We also see a number of products being launched that may have good intentions, but may not have a good, disciplined investment process. The broader investment industry is coming around to recognizing that this more rigorous approach must be used.
Despite the growth, many investors continue to be skeptical about the investment performance of ESG strategies. The common wisdom has been that if you limited your investable universe by anything other than financial factors, you would limit your returns. However, research has shown that more and more, strong performance and sustainability often go hand in hand. We have seen for years that investors who incorporate sustainability into their portfolios have been able to generate strong performance. Some of this performance is due to the skill of the ESG-focused managers, but some is also due to the objective value and advantage that including this broader set of tools can add. To help illustrate this “ESG advantage,” a team of professors at Harvard studied 180 companies from the early 1990s through 2010, splitting the group based on whether companies voluntarily adopted environmental and social policies, and found that, “in the 18-year period we studied, the High Sustainability firms dramatically outperformed the Low Sustainability ones in terms of both stock market and accounting measures.”
In a world where outperforming the benchmarks can be a difficult at times, and active stock and bond-pickers are always searching for an edge, the strong performance delivered by companies with good environmental, social and governance practices is reason enough for the lines between “social investing” and “investing” to blur.
As the investment industry begins to embrace this reality, we keep looking ahead to find forward-thinking companies, money managers and perspectives to help investors achieve their goals. We believe that the investment opportunities of tomorrow will continue to be found in companies that are addressing the opportunities and challenges of the future. Looking at this future through an ESG lens can help increase the probability of success. •


Matthew M. Neyland is director of investments for SK Wealth Management in Providence.

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