Investors are faced with many options when they want to invest responsibly. To ensure they get the results they\u2019re after, investors must first sort through the principles that support each option, starting with what \u2018responsibly\u2019 means.<\/p>\n
In the following paragraphs, I will outline two very different understandings \u2013 first as practiced by investment analysts and second according to investor values or behavior \u2013 and then show where these two theoretical poles are beginning to merge.<\/p>\n
Investment firms which manage portfolios on behalf of another party (including mutual funds and exchange traded funds [ETFs]) are amongst the largest investors and many are signatories to the United Nations backed Principles for Responsible Investment (PRI), based in London, England. The PRI defines \u2018responsible investment\u2019 as the integration of environmental, social and governance (ESG) factors into the analysis and selection of investments, and into ownership activities such as engagement with management and the voting of proxies at shareholder meetings.<\/p>\n
Consistent with Modern Portfolio Theory (MPT), which among other things guides investors to broadly diversified portfolios, ESG integration does not limit the types of investments considered. Rather, it mandates consideration of the impact that material ESG issues might have on the risk and return profile of each investment \u2013 over and above what may be available from standard financial statements. Determining which ESG issues are material to a company and how to measure those issues is an emerging area of interest that has recently received a lot of high-profile support, including from Mark Carney (Governor, Bank of England, and formerly Bank of Canada) and Michael Bloomberg (former mayor of New York).<\/p>\n
The benefit to analysts of integrating ESG factors is the potential discovery of hidden risks that are not apparent on regular financial statements and a better chance at outperformance. The benefit to society (i.e. the reason this is considered \u2018responsible\u2019) comes from public companies paying attention to the ESG issues that are important to financial analysts, disclosing and reporting on those issues publicly, and in many cases, changing their corporate behaviour. Measurement and transparency lead to better ESG outcomes.<\/p>\n
ESG integration also requires consideration of material ESG factors on the ownership side of investing. By voting on shareholder proposals that seek better ESG outcomes, investors can further improve the ESG practices of public corporations. Large investors may even have a chance to engage directly with a company\u2019s management on environmental, social or governance issues \u2013 a \u2018behind the scenes\u2019 opportunity which can advance corporate ESG practices considerably. Active ownership leads to better ESG outcomes.<\/p>\n
This is only one side of the conversation. Notably, PRI\u2019s definition of \u2018responsible investment\u2019 does not involve personal values or the screening of investments for particular trending attributes such as high carbon oil (out); low carbon wind or solar power (in); tobacco (out) and strong diversity policies (in). In contrast, many investors have strong personal views about these and other issues, and want their investment portfolios to reflect their individual values. Fortunately for these investors, there are many mutual funds and ETFs willing to accommodate their principles.<\/p>\n
Screening of portfolios for particular attributes has a long history, rooted many decades ago in the exclusion of select stocks by certain religious organizations that were seen as anathema to their values. Eventually, the practice evolved into what is often called \u2018socially responsible investing\u2019 (SRI), \u2018ethical investing\u2019 or when tilted towards environmental issues, \u2018green investing.\u2019 It is based upon personal values and may be different for each investor. Screening may lead to a portfolio that is less diversified than MPT prescribes, but in practice, modest amounts of screening may have little impact, especially over the long term, and could have offsetting or larger benefits.<\/p>\n
Behavioral finance theory shows that control over one\u2019s choices instills greater confidence in the outcomes, which may result in a higher likelihood of staying invested during volatile markets. As well, investing according to commonly held values, such as concern about global warming, can send an important social signal. People often chat at social gatherings about their investments, sharing their personal perspective and affirming mutually held values. As our societal values evolve, so do the regulatory and legal frameworks that mandate (hopefully) better ESG practices. Corporations pay attention to their social licence and to the values of their consumers, and tailor their ESG practices accordingly.<\/p>\n
Notice that the processes for the analysis-based ESG integration and the behavior-based portfolio screening are quite different. Just as neoclassical finance and behavioral finance co-exist and explain different aspects of the stock market, so to do they explain different aspects of \u2018responsible investment.\u2019 With the two different investment approaches outlined, we can now explore where they are starting to overlap in practice.<\/p>\n
Some studies show that companies which performed well or showed improving ESG metrics often outperformed or had lower risk than their peers. While past results are not necessarily indicative of future performance, the studies do encourage further consideration and research. For example, another group of researchers is using this type of data to propose inclusion of ESG as a systemic factor within MPT \u2013 showing a robust theoretical model that ESG factors are generally underpriced in the market and that they offer higher returns and\/or lower risk.<\/p>\n
Many mutual funds and ETFs offer broad screens of ESG factors which align with commonly held values \u2013 a happy convergence of behaviour and emerging financial theory \u2013 and\u00a0they may use active ESG integration as well.<\/p>\n
While this article has focused on investment vehicles such as mutual funds and ETFs, many investors also hold stocks and bonds directly. Investors should discuss with their advisor how to best meet their responsible investment goals. Do they want to invest according to their values or follow MPT and rely on ESG integration, or use a blend of both? If values are part of the mix, it is important to ask if the investment performance of the screen is supported by research or if some diversification being sacrificed? Is there capacity to integrate ESG considerations into the analysis of stocks and voting of proxies, or should they rely on the expertise of a mutual fund or ETF?<\/p>\n
Responsible investing is an evolving field, both in practice and in the research that supports those practices. It has a critical part to play in improving corporate transparency and environmental, social and governance (ESG) outcomes, and investors have an important role in ensuring their money contributes to these responsible results.<\/p>\n
Investors are faced with many options when they want to invest responsibly. To ensure they get the results they\u2019re after, investors must first sort through the principles that support each option, starting with what \u2018responsibly\u2019 means. In the following paragraphs, I will outline two very different understandings \u2013 first as practiced by investment analysts and […]<\/p>\n","protected":false},"author":7472,"featured_media":24449,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"acf":[],"yoast_head":"\n