Eat your greens! A four-step guide to ethical investing
27 August 2018 | Portfolio construction
Like many kids growing up in the 1970s I was taught to eat everything on my plate. It was good advice, particularly as an active kid living in a rural setting. Through my teenage years, I had more discretion and the choices I made left a lot to be desired. Now, with a recognition that my metabolism isn't that of an active teenager, I'm making more healthy decisions about what I choose to eat and what I choose to leave on the plate.
A similar discussion has been evolving around environmental, social and governance (ESG) investing. Is it better to 'eat everything' or can leaving out undesirable exposures improve investment outcomes?
Here's a four-step approach that can help investors navigate the options.
Define your goals
Approaches to ESG investing can vary widely depending on investors' age and background. CFA Institute research suggests that women are more interested in ESG issues than men. And millennials are more interested than baby boomers.
Some investors may take a purely financial approach by targeting companies with favourable ESG practices to enhance returns or reduce risks.
Other investors may make a values-based judgement to exclude exposures to industries like tobacco, alcohol, gambling or munitions.
Understand your options
Portfolio screening can take two main forms—'exclusionary', which removes stocks or sectors or 'inclusionary', which up-weights 'good actors' and down-weights 'bad actors'. It's the difference between removing all the unhealthy food from your plate or reducing the portion size. Many investors may be driven by a values-based judgement to divest from companies whose activities they disagree with, even if it means suffering a penalty in the form of a more concentrated portfolio and performance deviations.
Advocacy seeks to influence positive change through the power of voting rights, rather than removing yourself from the conversation by divesting. One of the big ESG debates is whether it's better for asset owners to 'vote with their feet', or 'vote with their vote'. Advocacy can be an effective way of maximising financial returns without compromising diversification.
ESG integration incorporates risk exposure into the investment process. A company may be subject to a high degree of ESG risk, but if the price reflects that, then it may still form part of an investment portfolio. Many super and managed funds follow a similar approach.
Impact investing involves allocating capital to generate both a social or environmental impact and a financial return. Also referred to as triple-bottom line investing, it remains a small component of the ESG universe, and carries more complexity in the form of niche funds accessed through private investment vehicles.
Decide a course of action
Informed investors can then choose a portfolio solution that best aligns with their ESG goals and the available options.
Assess your strategy regularly
The ESG investment landscape is far from static. Not only are investor preferences changing, investment options are rapidly evolving, supported by a growing recognition that it's possible to do well while doing good.
Much like my changing approach to healthy eating, a systematic approach to assessing your strategy can keep your goals in close alignment with your investment portfolio.
Written by Aidan Geysen, Head of Investment Strategy Group at Vanguard.
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Head of Investment Strategy Group