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ESG Investment Evolution
Socially responsible investing (SRI) has existed for generations and is at the origin of investments that integrate ESG factors (environmental, social and governance). Ethical or negative screening was first used to exclude companies or entire sectors based on social or environmental criteria. For example, tobacco industry companies could be excluded because of their link to cancer.
The potential downside often associated with negative screening resulted in the creation of positive screening. According to this approach, managers must select companies based on a set of qualities rather than avoiding those with certain defects. It is at the origin of "Best in Class" investing and as opposed to negative screening, it does not automatically disqualify certain companies or industries. Managers try to find companies that show the best practices in each sector. For instance, instead of excluding the oil and gas sector, the manager will target companies with a good track record relative to peers, for example with regards to environmental and aboriginal issues.
Corporate Engagement and Shareholder Action
It has been shown that in some cases, shareholder activism positively influences corporate behavior. This includes dialogue with company management on key issues, filing shareholder resolutions and voting proxies based on ESG criteria. These advocacy efforts are largely aimed at prompting management to increase long-term returns and to improve the well-being of its shareholders, customers, employees, suppliers and communities.
ESG as a source of added value (alpha)
When properly built, ESG porftolios are increasingly seen as a source of added value - or alpha - as part of the investment process. Indeed, if a company excels in the management of ESG factors, it may actually improve performance and reduce future liabilities. Because of their experience and favorable reputation, the ability of certain companies to overcome the challenges of environmental assessments or land claim issues more quickly than others is an example of a potential benefit associated with expert management of ESG factors.
Nowadays, responsible investing means integrating ESG factors into investment decision making and ownership practices with the hope that these factors have a significant impact on financial performance. Through a more integrated approach based on ESG factors, companies that would have once been excluded as an investment option are now recognized for their efforts. Investors can therefore benefit from large corporations in industries that are perceived negatively. As today's companies are faced with higher debt and environmental costs, investment decision making must take future potential costs for shareholders into consideration.
Implications for the choice of manager and investment
Many managers and investment opportunities are available out there. So which ones should you choose ? Some managers' approach is to evaluate portfolios based on lists of companies provided by external suppliers. By proceeding this way, they cannot make well informed decisions, which can have unexpected impacts on the portfolio. Studies suggest that such selection methods may compromise performance. The best thing to do is to choose a manager who has fully integrated the approach based on ESG factors into his portfolio management and research process. The advantage is that an effort was made to understand ESG issues and their impact on each company, generating a stronger and more diversified portfolio.
If you would like more information on SRI based on ESG criteria, let's talk.