The investment community loves a TLA (three letter acronym) and after years of dominance, the ever-popular ETF (exchange-traded fund) has been overtaken in the acronym lexicon by ‘ESG’.
Interest from investors, advisers, institutions, and regulators alike has brought Environmental, Social, and Governance (ESG) investment considerations to the fore over many years. A topic that may have once been considered a niche or fad is now an enduring component of the investment decision-making process.
There is no shortage of examples that underscore why there is an increasing focus on the E, S and G outcomes of financial investments. In recent years, significant Australian weather events have added a dimension of lived experience to environmental considerations. Social justice movements around the globe have increasingly posed complex questions about the role of companies in driving equity. And the real-world impact of corporate governance issues has taken the topic out of the boardroom and into the headlines.
The breadth of issues demonstrates the broad scope of this catch-all acronym, which is made more complex when you consider the broad spectrum of investors driven by a range of deeply held personal views and individual investing goals.
Investors may be seeking to align their investments with their personal values on any number of issues or to address ESG risks that could impact long-term investment performance. For existing investors, this may mean looking at an existing portfolio seeking to understand where ESG fits, or considering making changes. For newer investors, ESG factors may be actively considered in the establishment of an investment plan and the associated investment decisions.
With all the variability represented by these three letters, clarity for investors begins with an understanding of the fundamental investment approaches and strategies that consider ESG matters.
Advocacy and investment stewardship
A key practice that isn’t limited to funds with a stated ESG strategy is advocacy and investment stewardship - which involves utilising share ownership to advocate for strong corporate governance on ESG-related issues. Primary activities include engaging with company boards and executives and voting on resolutions at annual general meetings. These efforts are aimed at ensuring companies disclose significant ESG risks, develop strategies to reduce them and report on progress - ultimately holding them accountable for practices that protect long-term shareholder value.
ESG integration
This more broadly defined method refers to a process where investment decisions are informed by an assessment of financially material ESG information. Primarily used by active fund managers to identify the risk or potential of a company, perhaps identifying an attractively priced and well performing energy company who is thoughtfully managing the transition to sustainable resources.
Exclusionary portfolio screening
As the name suggests, exclusionary screening involves excluding certain securities, industries or sectors from a broader investment. The exclusions are typically based on specific ESG criteria- for example, a global equities fund that excludes all companies that manufacture tobacco or weapons.
Inclusionary portfolio screening
On the flip side inclusionary screening, or proactive investment, directs investment towards companies that have higher ESG ratings relative to industry peers or other investment opportunities. Inclusionary investing could also involve targeting whole sectors that meet certain ESG criteria.
Impact investing
This strategy centres on targeting investments with dual objectives of supporting positive social or environmental outcomes while also generating a financial return. For example, a green bond where the proceeds are used to help the company make its manufacturing processes more energy efficient.
With an understanding of these approaches and their different applications, investors and advisers are equipped to consider ESG within a broader financial plan. In doing so ESG becomes a part of the process of weighing key investment considerations alongside other familiar fundamentals including goals, cost, diversification, risk and potential return.
Capable investment managers will continue to provide product options that address the increasing appetite for ESG investing, and while this could provide more options that reflect the diverse goals of investors more choice can bring a degree of complexity.
While investors will always benefit from carefully considering the available options, a product versus product comparison can never take the place of a clear understanding of how you want your own values and goals to be reflected in your investments.
Evan Reedman is Head of Product at Vanguard Australia, a sponsor of Firstlinks. This article is for general information and does not consider the circumstances of any individual.
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