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Last week, Advisor Perspectives published A Survey of the Academic Literature on ESG/SRI Performance. The piece compiled many of the best studies on performance, and the author, Marianne Brunet did an admirable job of trying to provide readers with a conclusion on performance. Ultimately, the conclusion was given that some studies determined ESG/SRI strategies helped performance, and others determined it hurt performance.
You can come to more meaningful conclusions on performance with ESG and SRI, but you have to make distinctions between the two to do so. Many practitioners lump ESG and SRI together but they are in fact quite different.
Defining sustainable investing
Investors are often confused over what “sustainable” investing actually is because there is no consensus on the definition. This is especially the case with socially responsible investing (SRI). SRI was originally developed to allow investors to avoid companies they disliked for ethical or values-based reasons. This original form of SRI is now called “exclusions” or “negative-screen” investing. Other SRI strategies have been developed, including positive screen or thematic investing, where only companies aligned to the investors’ values are bought. More recently, impact investing has become popular; here investors provide capital to innovative companies working to solve social problems like endemic unemployment or recidivism. SRI has expanded so much that some have relabeled it from socially responsible investing to sustainable, responsible and impact' investing. Many use these terms interchangeably.
The proliferation of investment alternatives for the concerned investor is certainly welcome, but the confusion that results is an unfortunate side effect. Below is an infographic that attempts to make meaningful distinctions between ESG, SRI and impact strategies.
The value-driven categories on the left include the investment approaches that are designed to not compromise on risk and return. Both conventional and ESG strategies aim to maximize financial return for the risk taken. They put financial return first, before any other issues are addressed. The values-driven' categories on the right include strategies that consider financial return after the investors' values have been satisfied.
There is, of course, a spectrum of funds with varying focuses on financial and social returns. Which of the two is prioritized differentiates ESG from SRI.
ESG integration is the explicit inclusion of environmental, social and governance risks and opportunities into traditional financial analysis based on a systematic approach and appropriate research sources.i ESG is about economic value. SRI is an attempt to incorporate ethics and social concerns into portfolios. SRI is about individual values.
Confusion arises in cases where economic and individual values overlap; for example, pollution is a risk to a company's profits and to a person's health. It makes perfect sense to avoid polluting companies for either reason. Many investors will do it for both. In these cases, a fund could be called ESG and SRI.
It is, however, important to not lump ESG strategies in with other forms of SRI investments when evaluating investment objectives and the resulting performance. The conclusions of research on the performance of SRI funds may not apply to ESG funds. The results of SRI or sustainable fund performance studies will be inconclusive because of the mix of investment objectives. Meaningful conclusions can only be made when making like-for-like comparisons. ESG funds that aim to maximize financial returns have different results from SRI funds that balance objectives.
For example, you would not want to compare an SRI fund charging 1.5% that excludes alcohol, tobacco, gambling, pornography and weapons to an ESG index ETF strategy with an expense ratio of 0.25%. The former is likely to underperform except in extraordinary circumstances, partly due to the exclusions, but more so because of the high expense ratio. The latter is going to deliver more market-like rates of return.
The academic research is certainly important to consider, as it shapes expectations going forward. In practice, the process of selecting an appropriate investment strategy for clients comes down advisors using their expertise in knowing their clients and their investments. If values are more important to the client than value, SRI might fit. If the client wants to maximize value, but invest in a way that considers sustainable criteria, ESG might fit. In either case, the advisor will have to use their due-diligence process to find funds that are appropriately diversified and have reasonable expenses to get the best performance.
Samuel Adams is CEO of Vert Asset Management, a California-based, dedicated ESG fund manager.
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