SRI/ESG/Impact investing is nuanced, complicated, and can be somewhat confusing.
It can also be controversial. While there are many advocates for this way of investing, there are also plenty of detractors who claim that it’s simply “virtue signaling” or that it doesn’t make a difference.
Added to this is the somewhat confusing landscape of terminology. The various terms and jargon used in this area of investing can be problematic to those less familiar with the space.
In my opinion, this investing mindset does make a difference but in different ways depending on how it’s applied. Three of the most prominent general categories included in this space are Socially Responsible Investing (SRI), Environmental, Social, and Governance (ESG), and Impact Investing.
Socially Responsible Investing
Socially Responsible Investing (SRI) is a broad category that focuses on alignment with values. It attempts to divest from “negative” companies and include “positive” companies.
In general, this divestment doesn’t necessarily make an obvious impact on companies, though there are arguably more subtle impacts that will be discussed shortly. It’s more about making a statement or aligning your money with your values as a reference or philosophy.
ESG
A subset of SRI is ESG (Environmental, Social, Governance) factors. ESG can incidentally align with your values, but is actually an additional screening tool used by managers to find companies who have the best rankings in those three categories. For example, does the company make good and sustainable use of natural resources? Does the company have good workplace safety? Does the company have an independent board? The better the score, the better the company manages those risks that can and often do impact their bottom line.
Generally, the risk metric and the values are aligned. Another example, an oil company is at risk of negative PR due to an oil spill. That is a reputational risk that can sink the stock price. Divesting from oil companies makes a statement about fossil fuels and avoids risk from the potential of an environmental disaster.
Another example is the idea that companies that have strong DEI (Diversity, Equity, and Inclusion) initiatives tend to (potentially) perform better because they take care of their team better.
So does divesting from certain companies affect their behavior? Many would argue that the effect is minimal. According to Jonathan B. Berk, a professor of finance at Stanford Graduate School of Business and an article by by Alexander Gelfand (“Why Divestment Doesn’t Hurt “Dirty” Companies”) which references this paper:
“… an overwhelming majority of investors would have to divest to have a significant impact on these companies’ bottom lines. But that hasn’t happened yet, and with just 2% of U.S. stock market wealth currently in “socially conscious” investments, it seems unlikely to occur in the near future.
By selling off their shares, investors give up any influence they may have had over a firm’s corporate policies. As a result, Berk says, impact investors would be better served by hanging onto dirty stocks rather than dumping them — since with enough shares, they could shift corporate behavior by exercising their rights of control.”
While this is one view, there is data that suggests there is an indirect but real impact of ESG when it comes to cost of capital.
According to Investopedia: “Cost of capital is a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.”
The higher the cost of capital, the less attractive a project may seem.
According to research by Ashish Lodh, Vice President, MSCI Research: “Companies with high ESG scores, on average, experienced lower costs of capital compared to companies with poor ESG scores in both developed and emerging markets during a four-year study period. The cost of equity and debt followed the same relationship.”
There is also evidence that ESG scores have a negative correlation with risk. In a study (“Weighing the Evidence: ESG and Equity Returns”) by Guido Giese and Linda-Eling Lee, both Directors at MSCI Research, the conclusion was that: “The finding supported with the highest statistical confidence level is the result that ESG characteristics had a positive effect on risk, in particular in mitigating tail risks. There is some evidence that ESG momentum (changes in ESG characteristics) was linked with portfolio performance, but a longer time series is needed to verify the existence of an ESG risk premium.”
Impact Investing
This brings us to impact investing.
Impact investing is (in my opinion) where real change happens. Impact investing goes a step further and includes an advocacy component. Funds that follow this path not only divest with an SRI alignment and by applying ESG screens, but also submit shareholder resolutions and make use of proxy voting and other tools in order to encourage companies to be better global citizens.
There are a number of notable major players in this space and you can read all about their advocacy work in their annual reports. These annual reports show advocacy work that includes:
- Pushing Microsoft to become carbon negative by 2030.
- Pushing Tullow Oil to add women to its board.
- Pushing a global coffee retailer to establish plastic waste reduction targets.
These funds families are built on a foundation of impact, and encourage positive change in companies held in their portfolios through shareholder engagement.
Here is a sample impact report that is similar to the ones I produce for my clients that shows the impact of their money.
In my opinion, if you want your money to go toward real change, you need to seek out the impact component. It’s fine to make a statement by investing in ESG-themed funds but divesting from fossil fuel companies (for example) can seem more nebulous when it comes to true impact – these companies don’t “feel” it as immediately or directly.
The true impact funds work toward improving the behavior of these companies with real advocacy work, which truly has a direct impact.
What About Cost?
One of the biggest arguments against SRI/ESG/Impact investing tends to be the perceived cost. There are some loud opinions in the world of investing that are convinced that cost is all that matters and that you should always be looking for the lowest possible expense ratio in the funds you invest in.
Philosophical commentary on that opinion aside, It’s true that SRI, ESG, and Impact funds tend to have higher costs. There is more overhead that comes with managing funds with a values-driven approach.
However, fund expenses don’t tell the whole story. When comparing fund performance net of fees (which is how performance is published), the returns end up being pretty comparable and it’s fairly easy to find SRI/ESG/Impact funds that perform on par with their passive counterparts.
Additionally, investors who are truly committed to making an impact with their money likely value other factors over fund expenses. It’s a reasonable and prudent tradeoff to pay a little more in expenses in order to have a deep level of impact with their money.
And they are in good company. ESG-related assets account for one in three dollars managed globally, according to estimates from Global Sustainable Investment Association.
For these investors, the drum beat of “low cost at all costs!” doesn’t have much sway.
Does SRI/ESG/Impact Investing Make a Difference?
Aligning your money toward progressive and positive values does make a difference. It’s not always immediately obvious, but as momentum and interest grows in this area, more companies will be encouraged to improve their impact on the environment, in social impact, and in corporate behavior.
Change takes time, but every dollar invested in SRI/ESG/Impact is a vote for creating a better world.
