The dynamic tension between what investors hope to be true and what they know to be true is particularly apparent in the realm of responsible investing.
A wide spectrum of responsible investment strategies meet at the intersection of personal values and investment portfolios — including socially responsible investing (SRI), sustainable investing, impact investing, as well as environmental, social and governance investing (ESG).
Although responsible investing is a common topic at investment conferences and in the media, misconceptions influenced by personal beliefs are hard to avoid.
Definitional distinctions are important. SRI strategies are typically exclusionary in nature, with roots in faith-based avoidance of sin stocks in the alcohol, tobacco and gambling industries. The SRI category is sometimes defined in an expansive manner, meaning that funds with minimal SRI exclusions (such as exclusion of only tobacco or firearms stocks) are categorized as SRI funds.
[See: These 7 Funds Make You Feel Good About Investing.]
Sustainable investing and ESG investing are terms often used to describe strategies that incorporate environmental, social and corporate governance criteria to complement traditional techniques for analyzing financial risk and return.
Impact investment strategies are targeted investments that seek to make a positive social or environmental impact. Impact investments often target mission-related priorities such as clean energy, affordable housing and financial inclusion.
The importance of due diligence is particularly important when thinking about impact investing, as use of the “impact” term is far from uniform. For example, one “impact” ETF includes Facebook (ticker: FB), Apple ( AAPL), Alphabet ( GOOG, GOOGL), Walt Disney Co. ( DIS), and Booking Holdings ( BKNG), formerly Priceline, as top holdings, which arguably is a significant extension of the impact investment definition.
Beware of “absolutist” claims about SRI. SRI approaches may not be as inherently harmful to investment returns as opponents claim, but also may not be a riskless alternative to conventional indexes. Despite the reflexive belief by some investors that any exclusion to an investment universe will harm potential returns, excluding a limited number of stocks from a thoughtfully constructed investment portfolio may not have a meaningful impact on investment results.
It is important, however, to be skeptical of overly promissory assertions about divestment or avoidance strategies.
A recent presentation from a well-known investment firm claimed that “you can divest from oil — or anything else — without much consequence.” The presentation illustrated that from 1989 to 2017, performance results of the S&P 500 index and a version of S&P 500 that excluded energy stocks were virtually indistinguishable from one another. Despite the favorable long-term results, the case isn’t necessarily closed in favor of fossil fuel divestment. Over the multi-decade investment time horizon typical for endowments and pension plans, performance differences over shorter-term periods offset one another.
Unfortunately, many individual investors don’t have the financial luxury or the patience to ride out performance swings over a multi-decade time horizon. During much of the 2000s, a period of strength for oil prices, S&P 500 index portfolios that excluded energy would have meaningfully lagged the index. The same dynamic has been true in recent months, with oil prices and oil stocks rising sharply while the broader market has stagnated.
Although fossil fuels remain the dominant source of electricity, renewables are increasingly competitive. Discussions about renewable power often are framed in beliefs rather than facts. Renewable power is now competitive in price with coal and nuclear, competitiveness that no longer relies on governmental subsidies. Ironically, coal and nuclear operators are increasingly seeking government subsidies in order to compete against renewable energy providers.
[See: 8 Ways to Build a Low-Cost Portfolio for Social Change.]
Although solar power still requires the sun to shine and wind power requires the wind to blow, advances in storage technology may eventually make it possible for renewables to provide the reliability required to provide 24-7 energy supply. Lithium-ion battery pack prices provide evidence into the improving cost dynamics for energy storage, as prices fell nearly 80 percent between 2010 and 2017, according to Blomberg New Energy Finance and GMO.
The path of adoption for renewables may be a long one, however, as the percentage of global electricity that came from renewable sources was only about 12 percent in 2017. Wind represents approximately 6 percent of U.S. electricity generation and solar approximately 1 percent, so coal and natural gas may remain critical sources of electricity for decades. The implications of a long transition may have profound impact on the medium-term attractiveness of fossil fuel stocks and utilities.
Performance results are far from conclusive. Some investors claim that responsible investment strategies offer inherently inferior performance, while others think that responsible investment strategies are inherently superior. The truth probably lies somewhere in between.
There is an intuitive logic to incorporating ESG considerations into the investment process, as ESG factors may provide material non-financial indicators of risk and potential returns. The brand impairment and financial costs experienced by BP ( BP), Volkswagen, Wells Fargo & Co. ( WFC) and Equifax ( EFX) illustrate the potential benefit from incorporating ESG considerations. If management quality, often evaluated in quantitative and qualitative terms, is a material consideration in stock selection, why wouldn’t it be appropriate to consider ESG factors?
Despite the intuitive appeal of funds that integrate ESG considerations or which employ an exclusionary approach, actively managed responsible investment funds have not delivered consistent outperformance relative to conventional indexes. There have been some promising results from the smaller pool of ESG index funds, however, some of the positive results for ESG indexes relative to conventional indexes may be transitory in nature.
The technology sector, the market leader in recent years, has tended to be overweight in ESG indexes; the lagging energy sector is either avoided or is underweight in ESG indexes. A change in relative performance between technology and energy could negate the recent performance advantage of ESG indexes; a reassessment of the ESG merits of leading technology companies is another potential game-changer, given controversies over privacy, labor conditions and tax avoidance strategies.
It may also be difficult to determine a universal truth about the ESG merits of a company. A study from State Street Global Advisors highlighted major differences in ESG ratings among several major rating firms. Other research points out significant ESG coverage gaps, particularly among non-U.S. companies.
Let the buyer beware may be good advice. The definitional distinctions, exaggerated claims and challenges make it vitally important for investors to define what they want to accomplish in social and investment terms while understanding the investment implications of a responsible investment strategy.
[See: The 10 Most Valuable Tech Companies in the World.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.
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5 Things to Know About Responsible Investing originally appeared on usnews.com
