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Education - June 21, 2018

Impact Investing – 4 Things You Need To Know

1. ESG and SRI — How they’re different

Environmental issues are more relevant (and trendy) than ever. Protecting and preserving the environment has become a focal point in modern politics — and it’s slowly but surely creeping into the investing world.

Situations like the BP (BP) oil spill in the Gulf of Mexico and the Volkswagen (VLKAY) emissions debacle have spurred consumers’ demands for corporate responsibility — not to mention an urgency among companies who want to protect their reputations (and share prices).

Environmental, Social and Governance (ESG) criteria is a hot buzzword among the investing community and is often considered to be the next iteration of Socially Responsible Investment (SRI).

Both ESG and SRI have their proponents and detractors — and, while they’re often part of the same conversations, ESG and SRI are differing concepts with differing criteria.

Kostya Etus, a portfolio manager specializing in ESG and SRI strategies at CLS Investments, an Omaha-based investment management firm, explains that SRI is a traditional, exclusionary screening method to avoid “‘sin stocks,’ such as those in the tobacco, alcohol, and firearms industries.” As the crusade against “sin stocks” became less of a focal point, and environmental issues came into the spotlight, SRI as a philosophy gave way to ESG.

Etus describes ESG as the new-school, inclusionary screening method to capture “companies that exhibit favorable traits, including:

  1. Environmental — reducing fossil footprint, managing resources wisely, etc.
  2. Social — respecting human rights, culture, workplace equality, product safety, etc.
  3. Governance — stewardship for shareholders, transparent, accountable, etc.”

While Etus’s definitions are quite succinct, the above is just one perspective on the terminology. Later, we’ll discuss how SRI and ESG are somewhat fluid concepts — a potential con for investors.

2. Comparing performance of ESG, SRI, & the field

Because ESG and SRI have become common investment strategies, we have incorporated this data into the YCharts platform. Screening for both ESG- and SRI-designated funds is as simple as adding a filter to YCharts’ fund universe.

We screened our universe for mutual funds and ETFs that are benchmarked against the S&P 500 Total Return and belong to the “Equity” broad category. We then separated the resulting 750 funds into the categories “ESG,” “SRI,” and “General.”

As of this publication, there are 34 ESG funds, 40 SRI funds, and 706 general funds that match the screening criteria above. It is important to note that 29 of the total 750 funds are defined as both ESG and SRI — we maintained all duplicates across the two fund designations.

As illustrated by the table below, ESG and SRI funds slightly outperform the general mutual fund, on average. Our analysis found that there is no significant difference in performance between the average ESG, SRI, and general fund.

ESG funds are a new concept for a lot of investors. While you can probably name a few of your favorite technology stocks off the top of your head, doing the same with ESG funds is likely more difficult. For that reason, we conducted a brief analysis of the top five ESG funds by assets under management (AUM).

Among these five funds, Technology is the highest weighted sector — 23.5% on average; that’s closely followed by Financial Services at 19.5% on average. The sectors to which these funds are least exposed are Real Estate, Communications, and Utilities.

The top-performing fund over the last five years, the Parnassus Endeavor Investor Fund (PARWX), returned just over 110% on 32.9% Healthcare exposure, 27.3% Technology exposure, and 0.0% exposure to Utilities, Basic Materials, Communication, Energy, and Real Estate, combined.

Some of the common top holdings across these companies are Microsoft (MSFT), Gilead Sciences (GILD), American Express (AXP), and CVS Health (CVS).

By looking at the Parnassus Endeavor’s makeup, it’s easy to see where returns — as well as potential risks — are coming from. As with any investment, it’s important to understand the underlying assets when entering an ESG strategy.

Read More:
4 Ways Wholesalers Use YCharts to Increase AUM
Can Active Management Still Add Alpha?
Millennials Don’t Use Advisors — 3 Ways You Can Change That

3. ESG: It’s what people want

So, the data doesn’t show that an SRI- or ESG-based approach captures or misses any significant alpha — but ESG looks for alpha you can’t see in your portfolio. ESG seeks to maximize what some call “social alpha.”

Social alpha refers to the non-financial impact that ESG investing aims to produce. Whereas SRI effectively penalized “sin stocks” by limiting their ability to accrue capital, ESG investing seeks to increase the flow of capital to companies who embody the Environmental, Social and Governance standards that investors deem holistic and admirable.

This concept resonates with millennials. Much like how individual companies have recently adopted environmental and social causes because they resonate more with younger generations, fund managers are building ESG funds to do the same.

In fact, the Morgan Stanley “Sustainable Signals” report of 2017 indicated that 86% of millennials were interested in sustainable investing and 38% were “very interested.”

Mitchell Kraus of Capital Intelligence Associates was quoted in InvestmentNews saying “[a]bout 30% of our clients are invested in ESG strategies, but about 70% of our new clients are investing in ESG.” Even if you aren’t sold on ESG and SRI strategies, staying on top of trends and millennials’ investing habits helps your firm stay modern and attract new, younger clients.

4. Cons of ESG: Definability & measurability

We alluded earlier to the fact that defining ESG criteria is subjective — this fact creates an issue when comparing ESG funds to each other and to non-ESG funds. It’s essentially up to the individuals creating the fund to determine exactly what their criteria and values are — and there may be a disconnect when compared to investors’ values.

For that reason, it’s important to thoroughly evaluate different ESG funds by looking at their holdings and reading a given fund’s prospectus — where the employed criteria should be explained. For example, companies such as McDonald’s (MCD), Nike (NKE), and Facebook (FB) are included in numerous “ESG” funds, yet one could make defensible arguments as to why these companies miss the target on some major ESG criteria.

Regarding measurability, ESG differs from more traditional investment philosophies in that social impact is a measure of its success. Unfortunately for pro-ESG folks, there’s just not a scientific way to measure that impact yet — at least not a good one.

Most of the data we have surrounding ESG strategies is backward-looking, but some in the investment community believe that social investing is still burgeoning. As the philosophy assumedly becomes more and more commonplace, analytics surrounding ESG will hopefully become more sophisticated and more capable of measuring both financial performance and social impact.

Using our data and tools, we’ve shown that employing an ESG or SRI strategy does not limit potential financial returns and, in fact, can boost performance, on average. This being considered, the goal of both SRI and ESG is social impact in addition to financial gains.

So, how do you maximize the social impact of your ESG or SRI strategy? A little more due diligence — evaluating holdings, reading prospectuses, and considering individual managers’ philosophies — is required. By diving deep on ESG, you can ensure that the funds you invest in ultimately match your and your clients’ goals and values.

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