Environmental, Social, and Governance (ESG) investing, once a niche offering, has pushed itself into the forefront of institutional and retail investment strategies alike. ESG encompasses several, often very different, investment philosophies. We’ll define a few here, discuss whether ESG should play a role in your portfolio, and make you feel like an ESGenius.
ESG investing covers an extensive array of strategies and investment styles. One version of ESG buys across all sectors and industries but avoids or screens controversial industries such as tobacco, alcohol, and pornography. Another version will only buy companies whose business actively pursues positive social or environmental impact, such as renewable energy companies. A third will buy everything and leverage its position as a shareholder to actively engage with companies to improve their governance, reduce their carbon footprint, promote equitable treatment of employees, etc. Think of ESG as a spectrum of strategies, where some are more selective than others, and some are not selective at all and still carry an ESG name, a practice known as greenwashing.
Should ESG play a role in your portfolio? It depends if you value principles over profits. If someone tells you that you can have both, they’re likely selling you an ESG strategy (and maybe has a bridge to sell you, too!). Constraints to a portfolio, such as not investing in oil or tobacco companies, by definition, can only limit returns, never enhance them. If a portfolio manager expects a constrained portfolio to outperform the broader market, they can replicate the same constrained portfolio in her unconstrained fund. However, if she anticipates the broad and unconstrained portfolio to outperform, she cannot reproduce that portfolio in the constrained fund.
However, one could argue that market participants focus so much on ESG factors in their investment process that companies that score higher in ESG factors may outperform companies that score lower in the future. Maybe, but what about the companies that score very low in ESG factors and get shunned by the market? Their price falls, and the cost of buying $1 of future profits decreases significantly compared to the same $1 of a high-scoring ESG company. One could argue that you can find deep value in low-scoring ESG companies for this reason and reap the rewards over time.
In the end, ESG should only influence your investment decisions if you care deeply about specific issues, and by that, I mean enough to give up potential returns on your investment. Constraining your portfolio is one way to show you care, but maybe giving to charity is a more direct and efficient expression of your core values and beliefs. Tune in next month to learn how to maximize the impact of your charitable donations on your favorite charities and your tax bill!