What is ESG Investing: All your questions answered and more.

So Paul, tell us: What’s ESG Investing?

In short, Environmental, Social and Governance (ESG) Investing is a type of sustainable or responsible investing that looks to achieve positive financial returns from your portfolio, while contributing to a better future.

ESG Investing deliberately includes environmental, social and governance factors in your investment decision-making process. These ESG factors are explicitly and systematically considered, together with the traditional things we look for when selecting investments (things like sustainability and scale of earnings) – not only because these factors are ‘nice to have’ but because they’re good indicators of high performance and long-term value.

The term ESG was first used in 2004 in the groundbreaking Who Cares Wins Report (and subsequent 2005 conference). Basically, the Report found that including ESG in investment decisions makes good business sense, contributes to more stable and predictable markets, and builds a better global society.

Around the same time, the United Nations Environment Programme Finance Initiative’s (UNEP FI) Freshfield Report further concluded that ESG factors are central to proper financial valuation and a healthy long-term investment strategy.

These findings seem kind of obvious to those who subscribe to ESG philosophy now, but at the time, it was really quite a radical challenge to the long-held view of shareholder primacy.

What factors does ESG consider?

ESG ratings weigh up a company or investment’s Environmental, Social and Governance impact.

Environmental Impacts include

• The company’s negative use of, impact on or risk to air, land, water, ecosystems, biodiversity, and animal and human health – whether potential or realised.
• The company’s positive impact on environmental fronts – for example, successful waste and pollution reduction efforts, energy efficiency or alternative energy initiatives.
• The company’s environmental policies and procedures – for example, waste and resource management plans, pollution prevention practices, emissions management and climate impact, and environmental reporting and disclosure practices.

Social Impacts include

• The company’s effect on society, including positive or negative policies, procedures and impacts on: human rights, diversity and equality, employment and labour relations, workplace health and safety, product/service integrity, supply chain management and supplier integrity, community stakeholder engagement, corporate philanthropy and volunteerism… to name a few.

Governance Practices include

• The way the company is run and the integrity of its systems of control and oversight.
• For example, positive governance practices might include: timely, accurate and transparent accounting and reporting practices, proven ability to manage or eliminate conflicts of interest (e.g. executive appointments, board appointments, political donations…), sound corporate risk management practices, and policies that foster accountability and the quest for enduring relevance (e.g. linking executive pay to longer-term drivers of shareholder value, rather than immediate, momentary gains).

You’ll notice ESG criteria are not mutually exclusive. For example, committing to equal pay or installing diversity quotas on a board of directors could realise both a social and a governance outcome.

How is ESG investing different from SRI?

ESG investing starts from the basis that a company’s Environmental, Social and Governance performance has direct financial relevance and these factors need to be considered alongside other aspects like sustainability and scale of earnings.

By comparison, Socially Responsible Investing (SRI) – sometimes called ‘Ethical Investing’ – relies predominantly on negative screening to rule out certain types of investments, based on a moral or ethical standpoint.

For example, for years we’ve avoided investments we felt caused disproportionate social harm – things like tobacco, alcohol, gambling, firearms and more recently, fossil fuels and live animal food production. This is a good example of SRI at work.

SRI can also use a combination of negative and positive screening to rule out certain types of investments and rule in or favour other types.

In this case, for example, you might screen out tobacco and guns, and also positively screen for renewable energy providers.

How are the returns for ESG investing?

Until relatively recently, sustainable investments had a rep for disappointing returns. For many people, when they heard ‘sustainable’ or ‘responsible’ they seemed to confuse this with charity – like doing good for your community is the reward and if you got a little financial return, all the better.

But a good responsible or ESG investment strategy isn’t philanthropy. It’s an investment and is designed to generate a return. And our evidence shows us that it does this rather well.

Our House View is also backed by recent research from the RIAA which found that “responsible investment funds outperformed mainstream funds over most time frames and asset classes.” Specifically, Australian and multi-sector responsible investments were shown to outperform mainstream funds across all investment time horizons, and International responsible funds outperformed over every period, except the one year time horizon.

Given that Kearney Group takes a long-term approach to investment strategy, we see only upside to an ESG informed portfolio – both financially speaking and for the world around us.

What are the drawbacks or limitations of ESG investing?

The main limitation of ESG investing is that there just aren’t that many investment managers integrating ESG in an explicit and systematic manner (or at least not with the appropriate level of reporting and oversight)… yet. In their latest Benchmark Report, the RIAA tells us that of the 165 investment managers they assessed, only “44 (27%) are applying a leading approach to responsible investment”.

Now I use the word “yet” deliberately because we know investor demand is growing rapidly, and the number of investment managers is following suit.

As the market for ESG has grown, data and reporting has gotten better. Each year that passes, global ‘standards’ are becoming more standard and more robust. And, with seemingly daily leaps in technology and AI, we’re also better equipped to interpret and draw insights from the fragmented and early data sets we do have.

So while our ESG and responsible investment options are still somewhat limited and reporting is imperfect at the moment, we firmly believe that leaders in this field just need to get started. By doing so, we’ll help create the necessary demand for change and force lagging industry players to catch up or be left behind.

What’s the difference between ESG investing and putting my money into an ‘ethical’ or ‘green’ Super fund?

The market for ethical super funds has exploded over recent years – and while doing something is certainly better than nothing, figuring out what’s best for your investments, beyond super, is still incredibly difficult.

It’s also important to note that just calling your fund ‘ethical’ or ‘green’ does not make it either of those things. Advertisers are acutely aware that now, more than ever, Australians are voting with their feet (in fact, nearly 80% of us are willing to switch our super or investments if we feel our fund doesn’t align with our values. This number climbs to 88% when we look at Australians aged 18-34).

So marketing teams are clued in, and are creating products to entice us using ‘green-washing’ and ‘conscientious investor’ language.

So – my word of caution: take your time and do your research. Look beyond fund names and product labels. Compare funds and look into their accreditation. RIAA is considered the gold standard here in Australia – but you still need to dig deeper.

Because the RIAA doesn’t define what it means to be ‘responsible’ or ‘ethical’, you need to look into each fund’s fine print and values.

Do you feel super passionate about green energy? A fund can be accredited as ‘excluding fossil fuels’ whilst still earning up to 20% of its revenue from them.

Indeed, one of Australia’s four ‘fully ethical’ funds, doesn’t apply a revenue‐based exclusion to companies involved in exploitation of oil and gas. Further, they confirm they will not blanket exclude companies that derive the majority of their revenue from oil until electric vehicles make up 5% of new sales.

That’s all to say, you shouldn’t turn to the RIAA to tell you how ethical or responsible a fund is (or is not). Rather, you need to do the base research and then look to the RIAA for indication as to whether the fund is walking their talk and delivering on their charter and stated values.

So what’s the ethos behind Ethos Managed Portfolios?

We’ve always believed that good investment is responsible investment, and that investment returns don’t have to come at the expense of our community or planet.

So Ethos Managed Portfolios were created specifically for those who want an agile and actively-managed portfolio, AND contribute to a better tomorrow.

One way we do this is by partnering with fund managers who use a leading approach to environmental, social and governance (‘ESG’) investing. Their positive, negative and norms-based screening allows us to offer our clients high-performing investment options that explicitly strive for greater breadth and depth of ESG impact. See more on that below or here.

Broadly speaking, Ethos Managed Portfolios seek renewable and sustainable sources of investment, and things that positively contribute to our community, environment and a progressive business landscape. To this end, we also avoid extraction and exploitation – the digging up of coal and fossil fuels, big polluters and destructive environmental practices, products that contribute to social harm (tobacco, booze, gambling and weapons), abuses of people, animals and human rights.

Our ESG Classification Model and internal fund manager screening processes help us to achieve these noble aims. More on that below.

What do we mean by seeking breadth and depth of ESG integration?

As part of our commitment to transparency and supporting a growing ESG market, we set about designing our own Classification Model with associated scoring system to reflect our desire to advance both the breadth and depth of ESG integration across the Ethos suite.

For our Classification Model, we first mapped together the RIAA’s Responsible Investment Spectrum and Zenith’s evolving Responsible Investment Framework (which spoke to one another quite nicely). Then, we built out our own scoring system that allows us to rank and identify areas in which we can:

1. increase the number of Ethos funds that are invested under a responsible investment regime (quantity / breadth of ESG integration); and
2. progressively take up increasingly regenerative (not just sustainable) forms of investing (quality / depth of ESG integration). For example, where two funds are considered otherwise equal, we would select the fund with the most aggressive ESG profile.

Further, to support our Classification Model, we’ve also developed our ‘Ethos Ethos’ – an ESG manifesto of sorts. This document outlines our guiding principles and a laundry list of the things we are seeking to include and seeking to avoid in our portfolios. We’ll be actively pursuing these ambitions over the coming months and years, working to ever-improve our RI capability and offer to clients.

You can read more about Ethos Managed Portfolios and what we prioritise here.

And how are Ethos Managed Portfolios constructed and managed as an ESG investment?

When we’re constructing the Ethos Managed Portfolios, we first begin by looking at strategic asset allocation. That is, we work to balance a portfolio’s risk and return by weighing up different asset classes (e.g. shares, cash, bonds) according to our House View of the market, our suggested investment time horizon and the portfolio’s risk tolerance.

Then, we look at the range of investment managers who are performing well within each sector.

Next, we filter that list of investment managers to prioritise those who are applying a leading approach to ESG, and have proven ESG performance as a key factor in their investment decisions.

When we get to this stage, our decision is usually pretty straightforward – and what we’re left with is high-performing investment managers, in our desired sector, with a proven track record of doing good.

Then, we put the portfolios through the ringer, testing their construction and ensuring their diversification levels are where we want them to be.

The Ethos Investment Committee is responsible for oversight of the Ethos Managed Portfolios. So this is the body that monitors market conditions and portfolio performance. It undertakes investment research and analysis, and it also manages changes to Portfolios as they’re required. The Committee is currently chaired by David Wright, who is the founder and CEO of Australia’s second largest research house, Zenith Investment Partners.

Why should I consider ESG when making investment decisions?

ESG analysis is a pretty powerful tool and adding it to your arsenal allows you to:

Avoid risk.

ESG screening can alert us to companies with bad underlying practices and helps us avoid risk (Think BP, Volkswagen and Equifax. What do these companies all have in common? They’d all been sounding ESG alarm bells for years and ESG data providers had downgraded all three companies before their spectacular crash-and-burns. More on that here.).

Do good.

Beyond alerting us to danger, ESG also just allows us to do a little bit of good in the world. It allows us to put our money where our mouth is and meaningfully support the best performers, new ideas and emerging industries.

Understand true, long-term value.

If doing good for the community and planet isn’t enough for you… there are mountains of evidence linking ESG performance with financial success and enduring relevance.

By looking at traditionally ‘non-financial’ costs (things like environmental, social and governance performance), and accounting for these impacts appropriately, it’s easy to see that EBITDA (total profit) in isolation isn’t a sufficient gauge of value. That is, many ‘profitable’ companies and high-performing investments are actually racking up social and environmental costs that exceed their total earnings.

Knowing this and factoring ESG into your investment decisions is, in our view, a crucial step in determining the true, long-term value of a company or investment.

In short:

From a human perspective, considering ESG is a good thing to do.

From an investor’s perspective, considering ESG is the strategic thing to do, financially-speaking.

And in my opinion, from a financial adviser’s perspective, considering ESG is, quite simply, our job.

If ESG has direct financial relevance, can be predictive of risk and reveals true long-term value, then failing to provide ESG analysis on investments is failing our moral obligation to our clients and our community.

Because – what good is a ‘good return’ now, if it comes with such an enormous future cost? What good is retiring early, if when you get there, you can’t breathe the air or drink the water or the society you retire to has become dangerous or unlivable? What good is abundance now, when it comes at the expense of our ability to live well into tomorrow?

These are big philosophical questions. And we believe ESG investing can be part of the answer.

How do I know how ethical or sustainable my portfolio is?

If you’re not sure how responsible or ethically-aligned your current portfolio is, that’s okay. You’re not alone. Most people don’t know and frankly, most financial advisers won’t even be able to give a straight answer without considerable effort and research.

But you’re asking the right questions.

Click here to learn more about sustainable investing, ESG, our Ethos Managed Portfolios or how you can get your money working harder for a better future.