ESG Investing Beyond the Numbers

In our first of three ESG articles, we looked at the risk and return profile for ESG strategies. In this article, we weigh the benefits and potential pitfalls to ESG investing.

Historically, equity investors were placed in one of two camps, a value or growth investor. Over the years, the types of equity investment styles have increased, to now include strategies such as environmental, social and corporate-governance (ESG) investing. With momentum driven by investors, Wall Street firms are critiquing companies based on their sustainability factors or ESG standards.

Choosing an ESG Strategy: Not So Simple

Picking an ESG strategy is not just a matter of risk/return analysis. Innovation of investment products has provided financial advisors a plethora of options that they must understand in order to determine the most suitable investments to help achieve their client's objectives.

The decision to include or not include ESG investments into a client's portfolio is more than just focusing on the risk-return trade-off and diversification benefits they may or may not provide. The decision may come down to investors feeling morally compelled to invest in companies that follow the strict ESG guidelines.

Next, we evaluate some of the benefits and drawbacks to ESG investing that financial advisors may want to consider before implementing the strategies into a client portfolio.

Benefits to ESG Investing

Growth: There is a growing belief that environmentally conscious companies who manage their internal and external relationships well and maintain strong corporate governance will experience sustainable long-term growth into the future.
Influence: Your investment can materially impact society and the environment as a whole. You can vote with your dollar for causes that matter, while investing in something you are passionate about.
Sustainability: It provides investors with the opportunity to reward ethical companies, who in turn, should experience long-term sustainable growth.
Commitment: Chasing returns is one issue that plagues investors as they have the "fear of missing out" syndrome. Investors who focus on investing in a cause they are passionate about are more likely to buy and hold, rather than try to time the market, when they believe their investment will make a better tomorrow.

Potential Pitfalls to ESG Investing

A challenge in ESG being relatively new is there are multiple interpretations of ESG. Investing in companies who place emphasis on ESG seems straight forward, but it means different things to different people. ESG standards are becoming more commonplace; however, portfolio managers may differ in their ESG interpretations, while individual investors may have differing opinions on what they think social and economic sustainability should look like.
Due to the newness of the investment style and its subjective nature, it is difficult to find tools that allow financial advisors the ability to conduct comprehensive analysis on different products while having to consider the unique interpretations of ESG. MSCI ESG Research provides financial advisors an application to analyze products, but until there are more comprehensive applications, this will remain an obstacle.
As we previously mentioned, the decision to invest in ESG strategies is often more than just about performance. However, people invest their money in hopes of securing a financial goal in the future. Some investors may place more emphasis on ethics versus performance, which may hinder overall portfolio performance. In our previous ESG article, we discovered that ESG strategies have lower Sharpe ratios compared to the broader market, so it's important to not completely overlook the performance and risk characteristics of an investment when incorporating ESG strategies in a client's portfolio.

In Conclusion

Incorporating ESG strategies in a client portfolio in large part comes down to personal feelings on environmental, social and corporate-governance standards. Clients may be willing to sacrifice some performance in order to vote with their dollars on topics they are most passionate about. Additionally, financial professionals will need to overcome the lack of analytic applications to find the best strategy that falls in line with the client's unique interpretation of ESG investing.

Individuals and corporations alike are putting a greater emphasis on reducing their carbon footprint, which provides investment opportunities for investors. Investment management companies are listening, as they are providing investors with an expanding array of compelling stories. There are many reasons to include ESG strategies in your client's portfolio, however, it is important to understand the drawbacks that exist when considering and evaluating ESG investments.

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Ryan Nauman is a market strategist at Informa Financial Intelligence. His primary focus is providing value-added market and investment insight along with educating buy-side participants on investment analytics and portfolio management concepts. Before joining Informa Financial Intelligence in 2012, Ryan spent over a decade in the investment management industry as an investment associate while overseeing more than $1 billion in assets. Ryan holds a B.S. in business computer information systems from St. Cloud State University.