What can investors expect from "socially responsible" investing?
Awareness of environmental damage and scandals involving working conditions in developing countries at certain subcontractors of large corporations has prompted many investors to use their savings to influence corporate practices.
Pascal Nguyen, University of Montpellier
Investment products labeled as “socially responsible” (or SRI) have thus grown rapidly. These are also identified by the acronym ESG, which reflects their three key areas of focus: the environment, social issues, and corporate governance. More than 500 certified funds are currently available in France through major financial intermediaries. Their performance can be tracked on the Boursorama website.
According to figures from the Global Sustainable Investment Alliance, ESG-driven investments now total nearly $30 trillion worldwide, accounting for approximately 10% of total financial assets.
And interest in this segment shows no signs of waning. Many asset management firms are launching new SRI-labeled funds, or are deciding to focus entirely on this type of investment.
Investors now have access to a wide range of investment products, including both stocks and bonds, particularly green bonds.
See also:
Green bonds: a financial instrument for protecting the environment
They can also invest in exchange-traded funds, known as “trackers,” which aim 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 catalyst
Driven by ethical concerns, SRI initially sought to exclude companies involved in socially objectionable activities—such as the sale of alcohol or tobacco, or the arms trade—before favoring companies that are more respectful of the environment or human rights and that provide good working conditions for their employees.
However, the difference from conventional investing has long seemed marginal due to the difficulty of obtaining the necessary data or verifying its reliability.
With non-financial disclosures becoming more comprehensive and of higher quality in response to strong demand from investors, it is now possible to better identify responsible and irresponsible companies, suggesting that the differences between them will become more pronounced in the future.
The COVID-19 crisis appears to have acted as a catalyst, as ESG funds have shown a wider performance gap in their favor.
Thomson Reuters Eikon
How are ESG portfolios constructed?
When building their portfolios, ESG funds typically start by selecting a set of social and environmental indicators. These may include the amount of energy consumed in the manufacturing or transportation of products, or the amount of greenhouse gases emitted by the company.
These indicators are derived either from companies’ non-financial performance reports or from surveys conducted by research and information firms, such as Bloomberg or Thomson Reuters, for example.
The indicators collected are often adjusted to account for differences across sectors. They are then weighted to produce an overall score. Companies with the lowest scores—and thus presumed to be the least socially responsible—are excluded.
The funds then use a traditional financial approach that balances risk and expected returns to determine which of the remaining companies to include in their portfolios and in what proportions. As a result, some companies are overweight compared to what they would be if no ESG criteria had been taken into account. Others are underweight, or even absent from the portfolios.
SRI certification through labels
A fund’s commitment can be demonstrated by obtaining a certification. In France, for example, the SRI certification is endorsed by the Ministry of the Economy.
The certification is based on verifying that the fund takes companies’ social and environmental performance into account in its investment criteria, that it has the necessary resources to do so, and that its selection process is rigorous.
Finally, the difference must be substantive, meaning that the resulting portfolio must consist of companies with better ESG performance than those that were not selected.
What impact can SRI have?
At first glance, ESG portfolios do not seem very different from conventional portfolios. They even include companies that have been the subject of controversy. For example, Amazon—whose working conditions are frequently criticized by labor unions —was nonetheless included in the S&P 500 ESG Index. The same is true of Facebook, even though the company is known for its misuse of its users’ personal data.
This is because the rating reflects the company’s relative performance within its industry. Some industries are relatively polluting or consume large amounts of natural resources. To maintain a balanced portfolio, no industry can be excluded or even significantly underweighted, as this could negatively impact the portfolios’ returns.
However, reducing the weighting of lower-rated companies tends to hinder their growth. Conversely, top-rated companies—such as Danone, Schneider, Air Liquide, and L’Oréal, which are part of the STOXX Europe ESG Leader 50 index—enjoy an advantage through better access to the financial market. Empirical studies also confirm that these companies can raise funds more easily and at a lower cost.
But it is passive investing—which relies on tracking recognized ESG indices—that is expected to have the most significant impact. First, because it now accounts for the largest share of equity funds, thanks to minimal management fees.
The fact that ESG indices tend to include only the best-performing companies means that these companies are likely to attract significant capital inflows. Conversely, other companies will find it much harder to catch investors’ attention. This serves as a powerful incentive for them to improve their practices.
There is no doubt today that responsible investing is set to have a major impact on the economy. Investors who want to put their money to work for a good cause can invest with confidence in index funds that are broadly defined enough to be sufficiently diversified. The recent results show that their performance is on par with that of conventional funds, and their risk is actually lower.
Pascal Nguyen, Professor at the University of Montpellier, University of Montpellier
This article is republished from The Conversation under a Creative Commons license. Readthe original article.