An Introduction to Socially Responsible Investing (SRI/ESG)
The general public’s awareness of such issues as climate change, labor practices, and corruption has greatly increased in recent decades. We’ve all heard of huge multinational corporations caught (and fined for) polluting the environment, bribing government officials for permits and contracts, or exploiting outsourced workforces in developing countries.
Most of us have also heard the terms environmental, social, and governance (ESG) and socially responsible investing (SRI). They are used interchangeably in the investment community, as they relate to the same issues. Fairly new concepts (more or less a decade old), they define criteria of corporate governance, community and labor affairs, environmental issues, sustainability, and so forth. These attributes are not very tightly defined, and may mean slightly different things to different people. It comes down to how a company handles its business from environmental, social, and broadly ethical perspectives.
What ESG/SRI Means to Different Groups
Investors, who historically have been generally neutral on these issues and focused instead on yield and return, have become increasingly sensitive to which companies their money is invested in. Millennials are at the forefront of this change: as Generation X begins to retire, Millennials’ views are having a growing impact on the global investment landscape.
However, while Millennials are the first generation to consider sustainability as one of the critical factors in investments, they aren’t the only force driving socially responsible investments. Sovereign wealth funds are being scrutinized by the public and have become increasingly mindful of the SRI factors of their investments, occasionally to the point of divesting from existing holdings, followed by other entities who have some sort of explicit or implicit ethical mandate.
SRI doesn’t exist in a vacuum, though. It has some overlap with Sharia-compliant investments, which are also driven by ethical principles. SRI can also be in line with sanctions on investments in certain countries or regions, because these investments are usually in breach of SRI principles anyway. In fact, SRI criteria will likely be stricter than any globally or regionally imposed sanctions. And of course, SRI is in line with CFA® Institute Code of Ethics—if not explicitly (at least not yet), then definitely in spirit.
How Does It Actually Work?
Socially responsible investing will give substantial consideration to ESG factors, along with the broadly defined long-term sustainability of the business (as opposed to focusing mainly on quarterly or annual earnings and dividends) as part of the investment screening process. The factors will be defined and adopted differently by different groups, as they aren’t, as mentioned earlier, uniformly defined and quantified. Some socially responsible funds, for example, will eschew oil companies entirely, while others will allow them in their portfolios as long as they have long-term sustainability initiatives in place (e.g., increasing focus on renewable energy generation). Socially responsible funds will not invest in arms manufacturers, tobacco companies, coal, and other such businesses, though.
So, ethical and sustainable companies will make it to the portfolio, while the less ethical ones will not. As part of the screening process, ESG factors will of course be critical, but they’re not the only factors considered. Besides being ethical and sustainable, the company also needs to satisfy other investment criteria.
The Impacts of SRI/ESG
Ethical and sustainable companies making it to the portfolio will have a tremendous impact, far beyond any individual fund. Why? For a number of reasons. The primary one will be market impact. With equity and bond markets driven by supply and demand, the companies giving low consideration to ESG factors, will find themselves in lower demand. Lower demand—holding all other factors constant—will exert downward pressure on the stock price. No company wants that. The other aspect will be publicity: being branded as unethical and unsustainable (or at least, less ethical and less sustainable than others) means bad press. It’s something not just the investment community, but also shareholders, will pay very close attention to. More often than not, they’ll pressure the company to improve their practices. This goes to show that investing is not just about the instruments we buy; it’s also about all the instruments we don’t buy. Not buying is an investment decision, even if it’s not always obvious.
On the flip side, companies that score highly on the ESG criteria, will benefit. First, the demand for their shares (and thus the share price) will likely increase, and second, they will benefit from great press. The perception of the company among Millennial investors will be favorable, and shareholders will be happy. Besides that, there’s a big argument of common business sense: a company with a business model considered to be sustainable long into the future is more likely to be a good investment than one focused solely on quarterly earnings releases.
Unfortunately, it’s not enough to construct an SRI portfolio to guarantee a great, long-term return. For one thing, returns can never be guaranteed. And socially responsible investments haven’t been around long enough to conduct comprehensive and conclusive analysis (though it will definitely happen in the future). Still, from the common-sense perspective, for a company to be ethical, well governed, responsible, and respectful of the environment and its workforce is a very compelling argument.
A CFA Perspective
From a CFA-curriculum perspective, socially responsible investing has been a part of all three levels for some years now (CFA Institute has historically been on the forefront of new concepts in investments, such as ethics or behavioral finance). Recently, CFA Institute has increased its weight in the CFA exams. This recent increase sends a clear message: CFA Institute, which itself is a preeminent organization with a unique position in the investment community, recognizes the increasing significance of SRI/ESG factors in investing. Socially responsible investing may be new, but it’s here to stay. All CFA candidates and charterholders should be mindful of it, not just for the duration of their CFA exams, but also throughout their professional careers. If you’d like to read more on ESG, CFA Institute has a dedicated section on its website.
About the Author
Wojtek Buczynski, CFA, FRM, is an investment risk and compliance consultant with Northern Trust in London. He is part of the global investment risk and analytical services team. Prior to Northern Trust, Wojtek spent four years working for Bloomberg’s analytics team as an advanced specialist. He is a graduate of London Business School. His interests include behavioral finance (especially asset bubble formation), indie cinema, documentaries, and current affairs. He is an avid reader and a fan of Wired magazine. You can connect with Wojtek via LinkedIn.