For some investors, maximising their returns or beating a benchmark is not the only thing that’s important.
These investors, instead, attempt to create portfolios that reflect their values and beliefs.
As well as looking at the investment’s expected return, volatility and correlation with other asset classes, they will also look at the company’s corporate practices and policies to make sure they are in line with the investor’s principles.
This approach generally comes under the following categories:
- Negative/exclusionary screening, often known as ethical;
- Environmental, social and governance (ESG) factor investing;
- Impact investing.
Each is now considered in a bit more detail.
Negative/exclusionary screening is the original form of values-based investing and it aligns investments with beliefs by screening out companies, or even industries, based on specific criteria.
Examples of such criteria include a significant portion of the firm’s profit coming from alcohol, gambling, tobacco or weapons; or the company using animal testing or child labour. This is still the most widely used values-based approach globally.
ESG factor investing is newer and it involves searching out and including companies based on desired environmental, social and governance characteristics rather than excluding firms with undesirable business activities.
Some might argue that this is not new, as factors such as reputational risk and regulatory developments have always been part of traditional fundamental analysis and risk assessment.
The ESG factor approach, however, involves a more systematic consideration of specified ESG issues throughout the entire investment process.
Below are some examples of ESG factors:
- Environmental - climate change/carbon emissions and toxic emissions/waste;
- Social - health and safety of employees, data protection/privacy and community relations;
- Governance - diversity, compensation and business ethics.
Some ESG managers go beyond integrating their defined factors into their security selection process and actively support their principles through shareholder engagement.
Such fund managers will, for example, communicate directly with the company’s senior management to improve ESG practices or exercise their voting rights.
While many investors and managers use ESG factors for values alignment, others will include ESG in their investment process for risk management and as a source of potentially superior financial returns. In the case of negative/exclusionary screening, however, returns will always be secondary to the investor’s values.
Although ESG investing is not as large as exclusionary screening, it is growing more quickly.
Impact investing refers to investing for both a financial and social benefit.
The objective is to create a positive and measurable impact in solving environmental or social issues in addition to achieving a financial return.
Examples include clean technology, developing sources of renewable energy or backing entrepreneurs collaborating with community organisations.
