When it comes to investing, have you decided you’d like to be in good company – or companies – as you participate in our global markets? In other words, is ethical, or sustainable investing one of your goals?

Sustainable investing goes by many names, which I summarized in my last “No Dumb Questions” post. Most, if not all of them have one thing in common: They usually depend on an Environmental, Social and Governance (ESG) rating to measure and compare a company’s “good” and “bad” behaviours.

Today, let’s unpack How an ESG fund goes about determining what qualifies as “good” and “bad.”

 

Where Do ESG Ratings Come From?

The market has long depended on a number of reputable benchmarking, or index providers to help us measure, compare and rate other market components. Established providers include MSCI, FTSE, Bloomberg, Thomson Reuters and many others.

Not surprisingly, many of these same providers have responded to a growing interest in sustainable investing by developing ESG benchmarks as well. Then again, there are many newcomers too. Some of them may bring us innovations that will strengthen our ability to “measure good” even better.

The Rating Game

It’s not necessarily bad or wrong for different rating companies to compete against one another in the race to offer the best ESG-ranking mousetrap:

  1. Competition can be healthy. Competition contributes to efficient market pricing. Without getting too technical, more efficient pricing is one way our capital markets remain healthy and happy. And that benefits investors of all stripes.
  2. Competition provides choices. Different ESG rating systems provide different choices. Many investors may want to invest sustainably, but they may have very different opinions on what that means to them. For example, a June 2018 Wall Street Journal article suggested that MSCI ratings tend to focus on identifying “financially relevant [ESG] risks,” while FTSE seemed more focused on helping investors “change corporate behaviour.”

Which rating system is right for you? It depends on your goals. The point is, before you pick an ESG tool, it helps to know which rating agency it’s using to screen companies into and out of its line-up. Otherwise, you may think you’re investing in apples when you’ve actually just bought a bushel of oranges.

 

An Illustration in Action

Here at PWL, we typically favour ESG scoring systems that best complement our evidence-based investment strategy. That means we prefer rating systems that allow the fund manager to start with a large-enough basket of holdings to achieve the fund’s overall goals, and then screen out a subset of the worst bad apples.

For example, consider the Jantzi Social Index by Sustainalytics. This ESG rating system can be used by fund managers to build a basic Canadian stock fund. In its 2017 Methodology paper, it describes its process as starting with the wide TSX Composite Index – basically, Canadian stocks. It then applies a “set of exclusionary criteria” to create and sustain its eligible universe. Just as I described above, this means it throws out the worst holdings.

In this instance, Jantzi’s screening criteria eliminates certain industries or products entirely, including military contracts, nuclear power and tobacco. It also eliminates companies “that are having a major negative impact on stakeholders.” On a scale of 1 to 5, it throws out the Category 5 types. In other words, the ones who have been really messing up.

Of course, I’ve simplified things quite a bit here. As you might imagine, maintaining the index requires constant care and feeding. But hopefully I’ve given you a taste of what’s involved. For U.S. and international stocks, we tend to favour funds that depend on MSCI ESG rating benchmarks, each of which uses a methodology similar to Jantzi’s. They each start with a common U.S. and international benchmark, respectively, and then screen out the stinkers, as they define them.

Is today’s chat whetting your appetite for learning more? I hope so, because my colleague Raymond Kerzérho has published a sweet paper on the subject: “ESG Investing: Nothing Wrong in Doing Good.” One good deed you can do for yourself is to check out his work. Another is to subscribe to my “No Dumb Questions” YouTube channel, where I intend to keep the good stuff coming.