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ESG is the Next Generation in Enlightened Investing

May 18, 2017

Most investors would agree that, all things being equal, it would be preferable to invest in companies that make a positive impact on our world and society. Alas, things are rarely, if ever, equal.

To date, socially conscious investors have had a very limited landscape of investment options available and have been forced to choose between their financial and social goals.

Socially conscious investing has been available for decades through two vehicles – SRI and Impact Investing. SRI uses exclusionary screening to avoid exposure to certain sectors whose activities are not compatible with investor values. Companies on the exclusion list typically include those sin stocks involved in firearms, tobacco, alcohol, gambling, nuclear power and fossil fuels industries.

Impact investing involves direct, targeted investments in businesses or projects committed to generating a measurable social or environmental benefit. Impact investment opportunities are usually local and not suitable for investors who need to rely on consistent income or returns to meet retirement or other objectives.

Fortunately, enlightened investors now have another option that will let them invest in companies that prioritize certain socially-responsible goals – ESG investing. ESG integrates environmental, social and governance objectives into fundamental investment analysis.

Environmental standards evaluate how a company affects natural resources, the climate and other aspects of the physical world in which we live. Social standards evaluate how a company treats their employees and customers, as well as the impact the company has on the community in which it prospers. Governance standards evaluate a company’s leadership, oversight and shareholder rights.

In contrast to SRI, the ESG evaluation process is not designed to simply exclude companies, but rather to add another dimension of qualitative analysis to an investor’s due diligence. One only has to look at United Airlines' recent treatment of passengers to appreciate the importance of and interest in ESG evaluations.

Driven by investor interest in this value proposition, ESG is in the early phase of accelerating growth. In fact, 60 new ESG-themed mutual funds and ETFs have launched since 2015. More importantly, Morningstar has recently released their Five Globe metric that gives each fund a Sustainability Rating that can easily be evaluated.

The traditional dilemma is that socially conscious investing is a win-lose proposition – the environment and humanity win, while the individual investor loses by accepting sub-par performance. However, recent research has found this effect to be greatly exaggerated. Studies have conclusively demonstrated that the evaluation and selection of companies that have strong ESG scores are not necessarily or even likely to be characterized by lower financial performance.

Researchers at the University of Oxford proved this thesis in 2015 with their comprehensive study, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, which combined the findings of 200 empirical ESG studies. It concluded that companies with robust ESG practices demonstrated better operational performance over extended time periods. The research also showed that diligent ESG practices have a positive influence on investment performance.

Additionally, a 2015 study by Hong Kong University of Science and Technology, The Role of Governance relative to Environmental and Social Factors in Equity Returns, found that sustainability-themed investments perform just as well, if not better, than competing products without a sustainability element.

These studies have demonstrated that companies with strong socially conscious and ESG-focused practices have actually experienced improvements in both risk mitigation and financial results.