Investors are becoming increasingly aware of both the social and financial implications of their investment decisions. This concept, known as economic, social and governance (ESG) investing, has been identified by several different names including socially responsible investing, impact investing, mission investing, or sustainable and responsible investing.

What are some types of ESG investing? What are some of their benefits and drawbacks? How are funds utilizing these practices? Here’s the lowdown.

The objective of socially responsible investing is to move beyond pure financial economics and target social issues involved in investment decisions. The Global Sustainable Investment Alliance showed assets under management incorporating these practices reached $21.4 trillion at the beginning of 2014. A CFA Institute member study found that 73% of respondents took these issues into consideration when managing risk.

Types of ESG Investing

Passive—A passive socially responsible investing policy is characterized by divesting from certain asset classes that conflict with an organization’s ethical values. Industries could include firms that test their products on animals, alcohol and tobacco companies, organizations that manufacture firearms or other weapons, or gambling establishments. Another commonly targeted industry in passive socially responsible investing is energy companies that extract oil, natural gas or coal from the earth, which negatively impact the environment. These funds may also divest from industries that operate in countries with poor human rights records, including Sudan and Iran.

Active—An active approach is characterized by aligning organization beliefs with ethically applicable asset classes and moving funds into those industries. These industries include those that invest in alternative energy sources such as a wind, hydroelectric or solar power; organizations dedicated to stewardship, consumer protection, gender and racial equality; and those that promote overall human rights.  Organizations may also invest in local infrastructure to support investment and growth in their geographic area.

[Free Member Webcast, Tuesday, May 9: Understanding and Embracing Environmental, Social and Corporate Governance (ESG)]

Benefits and Drawbacks of ESG Investing

Pros

Allow organizations and individuals to operate in good conscience—After the Sandy Hook Elementary School shootings in Newtown, Connecticut in 2012, investment managers reported large numbers of investors selling their shares in firms that sold weapons. These individuals were then uncomfortable with the products being sold to fund their retirement plans. Similar events occurred after the British Petroleum oil spill in the Gulf of Mexico in 2010.

Incentivize ethical behavior from organizations—Shareholder price is a key driver for change for oil companies, tobacco companies and alcohol companies. Divesting from these funds can incentivize ethical behavior and, in turn, positive social change, motivated by simple economics. Supporters also state that ethically motivated investing can increase the organizational transparency of organizations with poor ethical track records.

Cons 

Limit potential higher investment returns through divestiture—Using the passive style of socially responsible investing, funds often remove their funds from entire industries. What if these industries happen to perform well in certain economic circumstances? For example, investment research has shown that in times of economic downturn (like the 2009 economic recession), “sin” industries such as alcohol and tobacco companies have performed well historically. Even since the 2009 economic downturn, stocks with high environmental, social and governance ratings have lagged behind “sin” stocks.

[Advanced Investments Management, September 25-28, 2017 at The Wharton School University of Pennsylvania, Philadelphia, Pennsylvania]

Risk of ERISA Implications—Plan fiduciaries that oversee pension assets have a strict liability under the Employee Retirement and Income Security Act of 1974 (ERISA). Fiduciaries that fail to “act solely in the interest of plan participants and beneficiaries,” fail to properly “diversify plan assets,” or do not take into consideration the “projected return of the portfolio relative to the funding objectives of the plan” can face severe penalties, given the potential of significant investment losses. While there are no specific ERISA provisions addressing the topic, the U.S. Department of Labor has issued a number of opinion letters, commentaries and interpretive bulletins that address socially responsible investing decisions. These comments clearly state that these notions are secondary to the fiduciary obligations of pension trustees.

ESG In Action

Despite the drawbacks, both organizational and individual investors are allocating significant funds to socially responsible causes. In 2012, the California Public Employees’ Retirement System (CalPERS) released a report detailing its efforts to incorporate sustainable investment practices across its $235 billion investment portfolio. These were significant implications, as CalPERS is the largest public pension fund in the United States Large public pension systems in New York and Chicago have invested funds using similar frameworks. Due to the size of these systems, others are expected to “follow the leader” and dedicate more funds to socially responsible causes.

To find out more information about ESG investing, attend our upcoming webcast. 

Justin Held, CEBS
Senior Research Analyst/Educational Program Specialist at the International Foundation