Today, many investors are asking how they can align their values with their investing activities. ESG investing is a great approach. What exactly is ESG? ESG stands for “Environmental, Social and Governance.” Simply put, ESG investing is a way to invest in companies that are better corporate citizens. These are the companies that are doing their best to make sure they reduce pollution, improve workforce safety, and have good policies in place to reduce operational risk. Investing with ESG in mind used to mean giving up the benefits of diversification in favor of a mutual fund that invests in a small number of companies; however, many advancements in gathering and analyzing data have provided greater insight into corporate activities en masse. With this information, rating providers have been able to identify ESG-related trends starting from the industry and continuing down to the specific company.
How ESG works
ESG rating providers review many aspects of corporate activities, both current and historical, that are relevant to the industry in which the company operates. For example, an oil company will have a greater emphasis on carbon emissions than a bank, whereas a bank would instead have a greater weight on data security. The review includes an analysis as to whether good corporate governance policies and operational risk controls are in place to maximize shareholder rights and limit liability arising from negligence. Further, companies are reviewed for any direct or indirect social controversies due to its activities, such as its line of business, the products it sells, or mishandling of customer information. After each aspect of ESG is analyzed and rated, the company is compared to its peers within the same industry and is given a final score.
How ESG is different
The distinction of ESG versus other methods of combining values with investing is that it seeks out the better corporate citizens without dramatically reducing the investible universe. Let’s take carbon emissions as an example. The S&P 500 is comprised of approximately 5.8% oil companies. If a client wishes to avoid all oil, the investible universe is reduced by 5.8%. Since there are fewer companies to invest in, the smaller investible universe increases the risk that the portfolio may perform differently from benchmarks.
However, what if we could frame the carbon emissions issue differently? From the ESG point-of-view, excluding oil from the portfolio may make the portfolio too different from the benchmark. The ESG investor recognizes that some oil companies are doing a better job keeping their oil rigs safe and reinvesting in research to advance renewable energy. The ESG investor would prefer to choose these types of oil companies and include them in their portfolio.
The potential benefits of ESG versus other methods
Historically, the primary way to create ESG portfolios was to establish broad industry exclusions; however, equipped with ESG scores by rating providers, new funds have been developed that reduce the need to create hard exclusions. The benefit of this is twofold: funds can be constructed to mimic traditional index performance with greater accuracy and the investor does not need to accept considerably more risk to invest in ESG. An additional factor that hindered ESG was that it used to be more expensive than traditional investing; however, low-cost ETFs and mutual funds have been created to track ESG indexes.
How we can help
ESG is a maturing field that no longer bears the burden of broad industry exclusions, dramatically lower diversification, and higher costs that used to accompany the style of investing. Major developments in ESG research have enabled greater coverage and highly detailed reporting, allowing us to create ESG portfolios that are low cost and broadly diversified. We believe that our ESG strategy is well-positioned to accommodate clients that are considering ways to match their values with their investments. We are excited to be able to offer this option and we invite you to reach out to your advisor for more information if you are interested.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
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This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.