BMO Nesbitt Burns
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Socially Responsible Investing
Investing for the Future?
Evolution of ESG Investing
The origin of ESG (environmental, social and corporate governance) investing resides with socially responsible investing (SRI), which has been around for generations. Ethical or negative screening was initially used to exclude individual securities or entire sectors from investment consideration based on social or environmental criteria. A simple example is the exclusion of companies involved in the tobacco industry because of its link to cancer.
The potential downside often associated with negative screens led to the creation of positive screening. This involved investment managers investing in companies that demonstrated a set of positive values rather than avoiding those exhibiting negative qualities. This positive screening approach resulted in the concept of Best in Class. No longer were companies or industries automatically screened out of the investment universe. Investment managers tried to identify and invest in companies that had the best practices within each sector. Simply put, rather than excluding the oil and gas sector, for example, you would target companies with a good track record, compared to their peers, of addressing environmental and aboriginal issues.
Once investment managers identified the Best In Class companies, being actively engaged as shareholders has been shown in some instances to further influence corporate behaviour in a positive way. These efforts included initiating conversations with corporate management on issues of concern, and submitting and voting proxy resolutions. These activities are undertaken with the belief that socially responsible investors, working cooperatively, could guide management on a course that would improve financial performance over time and enhance the well being of the stockholders, customers, employees, vendors and communities.
ESG as a source of Added Value (Alpha)
Well-executed ESG investing is increasingly viewed as a source of added value – or alpha – in the investing process. If a company excels in the management of ESG factors, this can actually enhance the performance of the company and reduce future liabilities. An example of the potential benefit derived from adept management of ESG factors is the ability of some companies to navigate the challenges of environmental assessments or land claims issues more quickly than others because they have experience, and a favourable reputation, in these situations.
Today, responsible investing is defined as the integration of ESG considerations into investment management processes and ownership practices in the belief that these factors can have an impact on financial performance. By taking a more integrated approach with ESG, companies that would have been excluded as an investment option in the past, are now recognized for the positive work each may do, and as such, investors have an opportunity to benefit from great companies that may be in industries perceived to be negative. With companies now facing larger environmental costs and future liabilities, the decision to invest should clearly consider the potential future costs to shareholders.
Implications for Manager/ Investment Selection
With so many managers and investment opportunities available, how do you decide which one to select? Some managers have taken the approach to screen portfolios against lists of companies that have been provided by external vendors. In this approach, managers may make decisions on the portfolio that they do not fully appreciate. The result could be unintended consequences for the portfolio and research seems to indicate that this naive screening may compromise performance. Perhaps the best approach is to consider a manager that has fully integrated the ESG approach within their portfolio management and research process. The benefit being these investment managers have made a dedicated effort to understand ESG issues and the impacts these issues may have on individual companies, thereby creating a more robust and diversified portfolio.
For more information on SRI investments that employ ESG screening, let’s discuss.