Business Owner Mindset
By Tim Doyle, Chief Investment Officer, CFP®
Over the past decade, one of the most fascinating and often misunderstood innovations in the wealth management industry has been the broad acceptance, utilization and growth of ESG investing. ESG is an acronym that, generally speaking, represents the inclusion of Environmental, Social and Governance considerations when screening and selecting investments, and these considerations tend to focus on topics such as:
E - Carbon Emissions, Toxic Waste, Water Usage and Clean Air/Water/Land
S - Worker Safety, Human Rights, Gender Pay Equality, Customer Privacy and Data Security
G - Board Structure, Board Diversity, Shareholder Rights, Supply Chain Risk and Executive Compensation
However, if you ask 10 advisors to describe what ESG means to them, there is a good chance you'll get 10 different answers. While ESG may be well-understood by certain industry insiders, it is less well-understood by financial advisors and the general public. Therefore, we'll attempt to set the record straight as we address some of the most common myths surrounding ESG investing.
Myth #1: ESG investing is a fad, and won't be relevant in 3-5 years.
Reality: ESG investing is here to stay – and rightfully so. In fact, the relevance of ESG investing has never been more pronounced as climate change threatens the global economy, a pandemic stresses global supply chains and data security poses ever-increasing risks for corporations and, subsequently, investors.
We've also seen tremendous interest and growth in investment strategies that incorporate environmental, social and governance considerations. In fact, according to the 2020 Trends Report released by The Forum for Sustainable and Responsible Investment, total US-domiciled assets under management using sustainable investing strategies grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the start of 2020. This represents a staggering 42% increase, and growth is expected to continue.
Source: 2020 Trends Report -The Forum for Sustainable and Responsible Investment
Once a niche portion of the wealth management industry, ESG investing has begun to go mainstream as we've seen many of the world's largest asset managers begin to recognize the value in identifying environmental, social and governance opportunities and risks that may impact both short and long-term shareholder value.
Myth #2: ESG investing supports issues like clean air/water/land, gender equality and human rights (to name just a few) at the expense of investment performance.
Reality: This is easily one of the most common misconceptions surrounding ESG investing. When we discuss this strategy with investors, one of the first questions asked (and rightfully so) is, "That sounds great, but will this help me achieve my personal financial goals?"
Let's be clear, at its core, ESG investing is about identifying environmental, social and governance opportunities and risks that can potentially impact shareholder value. Think of it this way - prior to investing - would you have liked to have known that Equifax had its business sector's lowest possible Privacy and Data Security rating according to ESG data provider MSCI before the massive data breach that led to their stock's -30%+ selloff? Would you invest in a utility like PG&E without considering the environmental risks associated with its infrastructure throughout California?
While no wealth manager can guarantee that a particular strategy will outperform, we believe ESG investing presents the best opportunity to enhance risk-adjusted returns, and if stock analysts and researchers aren't considering the environmental, social and governance opportunities and risks associated with an investment, then they aren't doing their full due diligence.
Myth #3: ESG investing is as simple as excluding 'sin stocks' like alcohol, tobacco, gambling and firearm companies from a portfolio.
Reality: Over the past few decades, ESG and socially responsible investing (SRI) were generally accomplished through exclusionary screening practices, meaning that a client would tell their advisor, "I don't want to own any of the big tobacco companies," and the advisor would then make sure that this type of company was excluded from that client's portfolio.
However, true ESG investing is most effectively done on an inclusionary basis. This means that a variety of environmental, social and governance considerations are included alongside traditional fundamental analysis. ESG isn't a replacement - it's an enhancement to the best practices of quality research and effective due diligence.
One of the most exciting aspects of ESG investing is that it represents a true innovation in data science. Over the past decade, we've seen tremendous innovations and enhancements that allow ESG researchers and data providers to identify and measure opportunities and risks in ways that were once unthinkable.
However, in order to truly benefit from ESG research, investors must be wary that they do not fall victim to 'Greenwashing'. Greenwashing is a term used to describe when, for example, a mutual fund or ETF calls itself "The XYZ Large Cap Core ESG Fund", when all it does is exclude broad sectors like Energy. In a fund like this, there is no true inclusionary ESG research being done. They are simply excluding certain companies or industries, then labeling their fund as 'ESG' to generate interest and drive asset flows into the fund. It is the role of your financial advisor and their team to identify instances of greenwashing in order to protect you from deceptive practices.
Myth #4: Companies that have great E, S, & G ratings are always included in an ESG portfolio.
Reality: A company could manufacture rainbows and their factories could be powered by the laughter of children, but that doesn't necessarily make that company a good investment. As stated in myth #3, ESG research is an enhancement to traditional fundamental analysis, not a replacement.
Furthermore, it's important to note that not all ESG impacts are treated equally across all companies, sectors, or sub-sectors. Analysts and researchers talk a lot about the concept of materiality. This term means that researchers focus on the ESG risks that are most materially relevant to a company, sector or sub-sector.
To illustrate this point, we've placed a snippet below of the Materiality Map created by the Sustainable Accounting Standards Board (SASB). This 'map' identifies which ESG risks are most relevant to each sector or sub-sector, with the different shades of grey representing the level and severity of that material impact.
As you might expect, Environmental factors weigh heavily on Extractives & Mineral Processing companies, whereas Social considerations like customer privacy, data security and product labeling are much more relevant to companies in the Financials sector.
Source: Sustainable Accounting Standards Board Materiality Map
The concept of materiality is absolutely crucial, because it allows researchers to efficiently focus their efforts on the ESG topics that are most likely to impact shareholder value of companies in a particular sector. Again, just because a company is effectively managing material ESG risks does not mean that it is profitable, viable and worthy of investment dollars.
Myth #5: ESG data is imperfect and, therefore, has little value.
Reality: I chuckle whenever I hear an advisor state something to the effect of "ESG data is imperfect and the data providers often don't agree, so I don't trust this data and it shouldn't be used." This assumes that researchers, analysts, portfolio managers and advisors have ever worked with perfect data.
As an example, each year, Destiny Capital's investment committee painstakingly analyzes the annual Capital Market Assumption (CMA) data from many of the top financial research institutions in the world, and there is rarely agreement across these CMA reports. For example, JP Morgan may project that Large Cap equities will produce compound returns of 4.73% with volatility of 17.1%, whereas BNY Mellon may predict a 5.9% return and 15.2% volatility for that same asset class. These are material differences.
Yes, different ESG data providers may look at the same company and come up with conflicting assessments of underlying ESG opportunities and risks. This doesn't mean that this data has no value and should be ignored. It does, however, help to illustrate the crucial importance of manager selection when implementing any ESG investment. Selecting a manager who has experience and proven expertise in ESG investing is absolutely imperative in order to maximize the potential of this innovative, rapidly evolving strategy.
While ESG data clearly has value, we also recognize the need for standardization and - I hate to admit - regulation. There has been a push, particularly in the European Union, to standardize and regulate ESG practices related to non-financial reporting, disclosures, taxonomy, suitability, labeling, bank stress testing and benchmarking. Given the growth of ESG strategies in the United States, similar standards are necessary in order to, among other things, aid researchers and protect investors.
Myth #6: How I invest doesn't impact corporate decision-making, so why bother with ESG?
Reality: When purchasing an investment vehicle like a mutual fund or exchange traded fund (ETF), it's easy for investors to lose sight of the fact that equity investing equates to ownership. As an owner, you have a voice, and effective ESG strategies allow you to elevate your voice to impact corporate decision-making. An ESG investor not only speaks with their investing dollars, but through the crucial act of proxy voting.
Investors typically have one vote per share of stock (or mutual fund unit) and proxy voting occurs when an investor delegates their vote to a third party, such as a fund manager. These votes, in aggregate, can impact crucial decisions related to key topics like shareholder rights, executive compensation, board diversity, gender pay equality, the environmental impact of business practices, data disclosure, worker safety and human rights.
This is why, as it stands now, we believe that active fund management provides tremendous value relative to passive strategies like ETFs. Quality ESG fund managers should provide an investor with detailed Proxy Voting Guidelines that outline how the fund will vote on their behalf on all of the key issues listed above, and more. The fund should then provide proof of their proxy voting record, and how they voted on key ESG issues. This ensures that, as an investor, your voice is heard, and you leverage your investing dollars and your vote to advocate for positive change.
ESG represents one of the most exciting and rapidly evolving investment strategies in the wealth management industry. Future innovation and changes to the regulatory environment are bound to impact (among many other things) products, services, data and corporate decision-making.
We also firmly believe that money has meaning, and investors can enhance meaning by aligning their investment strategies with their closely-held values. Therefore, it's important for investors to partner with advisors who have a deep understanding of ESG investing, and how to effectively navigate this ever-changing landscape. Please reach out to our Destiny Capital / Entrepreneur Aligned team with questions about ESG investing, and how you can use this strategy to do well while also doing good.
Important note and disclosure: This article is intended to be informational in nature; it should not be used as the basis for investment decisions. You should seek the advice of an investment professional who understands your particular situation before making any decisions. Investments are subject to risks, including loss of principal. Past returns are not indicative of future results.