What can investors expect from "socially responsible" investment?

Awareness of the damage caused to the environment and scandals linked to working conditions in developing countries by certain subcontractors of major groups have prompted many investors to use their savings to influence corporate practices.

Pascal Nguyen, University of Montpellier

This has led to the rapid development of "socially responsible" (or SRI) investment products. These are also identified by the three letters ESG, reflecting their triple concern: environmental, social and corporate governance issues. More than 500 labelled funds are currently available in France from the main financial intermediaries. Their performance can be tracked on the Boursorama website.

According to figures from the Global Sustainable Investment Alliance, ESG-guided investments now account for almost $30,000 billion worldwide, or around 10% of total financial assets.

And interest in this segment continues unabated. Many asset management companies are launching new funds bearing the SRI label, when they have not decided to devote themselves entirely to this type of investment.

Savers now have a wide range of investment products to choose from, in both equities and bonds, including green bonds.

See also:
Green bonds, a financial instrument to protect the environment

They can also invest in listed index funds, known as trackers, whose aim is to replicate the composition of stock market indices such as the Dow Jones Sustainability North America in the United States, or the MSCI Europe ESG Leaders on this side of the Atlantic.

The Covid-19 crisis as a gas pedal

Driven by ethical concerns, SRI initially sought to exclude companies involved in socially reprehensible activities - such as the sale of alcohol or tobacco, or the arms trade - before favoring companies that were more respectful of the environment or human rights, and offered good working conditions to their employees.

However, the difference with conventional investment has long seemed marginal, due to the difficulty of obtaining the necessary data or ensuring its reliability.

With extra-financial information becoming more complete and of better quality, in response to insistent demand from investors, it is now possible to better identify responsible or irresponsible companies, which suggests more marked differences in the future.

The Covid-19 crisis seems to have been a real gas pedal, since ESG funds are distinguished by wider performance spreads in their favor.

How are ESG portfolios constructed?

To build their portfolios, ESG funds typically begin by selecting a battery of social and environmental indicators. These may concern the amount of energy consumed in manufacturing or transporting products, or the quantity of greenhouse gases emitted by the company.

These indicators come either from the extra-financial performance declarations made by companies, or from surveys carried out by analysis and information companies such as Bloomberg or Thomson Reuters.

The indicators collected are often adjusted to take account of differences between sectors. They are then weighted to give an overall score. Companies with the lowest scores, which are therefore considered to be the least socially responsible, are excluded.

The funds then use a classic financial approach between risk and expected return to determine which of the remaining companies to include in their portfolios, and in what proportion. Some companies are thus overweighted compared to the case where no ESG criteria would have been taken into account. Others are underweighted, or even absent from the portfolios.

SRI certification through labels

A fund's commitment can be attested to by the award of a label. In France, for example, the SRI label is supported by the Ministry of the Economy.

Certification is based on verification that the fund takes into account the social and environmental performance of companies in its investment criteria, that it is equipped to do so, and that its selection process is rigorous.

Finally, the difference must be material, i.e. the resulting portfolio must be made up of companies with superior ESG performance to those not selected.

What impact can SRI have?

At first glance, ESG portfolios don't seem very different from conventional portfolios. They even include companies that have been the subject of controversy. For example, Amazon, whose working conditions are often denounced by trade unions, has nevertheless been included in the S&P 500 ESG index. The same is true of Facebook, a company notorious for abusing its users' personal data.

This is because the rating reflects the company's relative performance within its sector of activity. Some sectors are relatively polluting or heavy consumers of natural resources. For the sake of balance, no sector can be ignored, or even overweighted, at the risk of affecting portfolio profitability.

At the same time, reducing the share of the lowest-rated companies helps to restrict their development. Conversely, the best-rated companies - such as Danone, Schneider, Air Liquide and L'Oréal, which are included in the STOXX Europe ESG Leader 50 index - benefit from better access to the financial market. Empirical research confirms that these companies can raise funds more easily and at a lower cost.

But it is above all passive investment, based on the replication of recognized ESG indices, that is likely to have the most significant impact. Firstly, because it now accounts for the largest share of funds invested in equities, thanks to its low management fees.

The fact that ESG indexes tend to include only the best-performing companies means that these are likely to receive considerable flows of funding. Conversely, other companies will find it much harder to appear on investors' radar. This is a powerful incentive for them to improve their practices.

Today, there is no doubt that responsible investment is set to have a major impact on the economy. Investors wishing to put their money to work for a good cause can invest without worry in index funds defined broadly enough to be sufficiently diversified. Visit recent results have shown that their performance is in no way inferior to that of conventional funds, and their risk is even lower.

Pascal Nguyen, Professor at the University of Montpellier, University of Montpellier

This article is republished from The Conversation under a Creative Commons license. Read theoriginal article.