What is Socially Responsible Investing?

Socially Responsible Investing (SRI) has gained attention thanks, in part, to the bad behavior of several multinational companies and the desire for investors to align their portfolios with their personal values. Think of Volkswagen’s emissions scandal or Uber’s poor corporate governance and data breeches. Those made international news and they’re just two among many examples. Companies are facing punishment for their wrongdoings not only from governments, but also from investors who register their dissatisfaction by avoiding and selling investments that don’t line up with their values. As a result, socially responsible investing has attracted a lot of attention in recent years.

Canadians are interested and we are a world leader in the area. Over $1.5 trillion dollars in assets are managed with social responsibility criteria in Canada. The biggest institutional investors, notably the Caisse de Dépot et Placements du Québec (CDPQ), Healthcare Of Ontario Pension Plan (HOOPP) and Alberta Investment Management Corporation (AIMCo), have created a worldwide initiative that aims to boost global efforts on climate change and gender equality. They were recently joined by Germany’s Allianz SE, London-based Aviva, and the California Public Employees’ Retirement System in this effort. Together, the group manages over $6 trillion dollars globally.

Large portfolio managers aren’t the only ones involved in SRI. We found that smaller portfolio managers and individual investors are also looking at these strategies for their investment portfolios.

But what is SRI and how can you implement it in your portfolio?

Socially Responsible Investing is a way of investing that takes ethical and social considerations into account, as well as financial objectives, in selecting investments for a portfolio. The most common way of measuring these considerations is through Environmental, Social and Governance (ESG) scorecards. As of now, there are over 120 ETFs readily available, based on indexes carefully constructed by the big research firms in the field like Sustainalytics and Morgan Stanley Capital International (MSCI).
With this in mind, there are basically three types of ESG investing strategies: Passive, Integration and Active.

Passive investing

This strategy is an attempt to get companies that are already held in a portfolio to behave better. For example, think of an S&P500 fund. A fund like this can’t choose which companies to hold, it has to hold the companies that constitute the index. However, the portfolio manager of an S&P500 fund can choose to cast the votes related to the shares held in the portfolio at the annual general meetings of the portfolio companies. What’s more, the portfolio manager can threaten to vote against management at the next shareholders’ meeting if the board of directors don’t take certain positive steps to improve their ESG ratings.

This is a powerful incentive for boards to listen! The largest asset managers in the world like BlackRock, Vanguard and State Street are starting to do this. They each now hold significant stakes in most of the companies in the world because of their size.

Integration Investing

Unlike the passive approach, where the ESG considerations are secondary to financial return in the portfolio selection process, an integration strategy places the ESG rating and risk/return profile of investment opportunities at the same level of importance. The manager uses ESG ratings, typically from third party research firms, to readjust portfolio company weights based on their ESG scores, attributing higher weights to companies that score well and lower weights to companies that score poorly. MSCI and Sustainalytics are two of the largest firms to produce ESG scorecards on publicly traded companies. I’ll discuss how they collect, analyze and weight their ESG data in a subsequent blog.

Active Investing

Active investing places the ESG rating of a company above its risk/return profile in determining its suitability for inclusion in the portfolio. Active investing excludes entire industries (screening) and seeks out opportunities to make an impact on society. Screening means excluding stocks that go against a set of values specified by the investor, such as excluding fossil fuel or tobacco companies. On the impact side, the investor will actively look for companies that have strong ESG policies and are committed to environmental or social change with much less regard for the company’s profitability and potential return. Examples of impact investments include green bonds to fund renewable energy projects, or micro-finance initiatives in under-developed African countries to promote entrepreneurship among women.

As you can see, there are several options for investors looking to express their values through their portfolio. In my next blog post, I’ll discuss the rigor behind ESG research. Is it simply “green washing” for marketing purposes, or is this serious research that actually differentiates and rewards good behavior over bad?