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Beyond the acronym, navigating important ESG choices

The investment community loves a TLA (three letter acronym) and after years of dominance, the ever-popular ETF (exchange-traded fund) has been overtaken in the acronym lexicon by ‘ESG’.

Interest from investors, advisers, institutions, and regulators alike has brought Environmental, Social, and Governance (ESG) investment considerations to the fore over many years. A topic that may have once been considered a niche or fad is now an enduring component of the investment decision-making process.

There is no shortage of examples that underscore why there is an increasing focus on the E, S and G outcomes of financial investments. In recent years, significant Australian weather events have added a dimension of lived experience to environmental considerations. Social justice movements around the globe have increasingly posed complex questions about the role of companies in driving equity. And the real-world impact of corporate governance issues has taken the topic out of the boardroom and into the headlines.

The breadth of issues demonstrates the broad scope of this catch-all acronym, which is made more complex when you consider the broad spectrum of investors driven by a range of deeply held personal views and individual investing goals.

Investors may be seeking to align their investments with their personal values on any number of issues or to address ESG risks that could impact long-term investment performance. For existing investors, this may mean looking at an existing portfolio seeking to understand where ESG fits, or considering making changes. For newer investors, ESG factors may be actively considered in the establishment of an investment plan and the associated investment decisions.

With all the variability represented by these three letters, clarity for investors begins with an understanding of the fundamental investment approaches and strategies that consider ESG matters.

Advocacy and investment stewardship

A key practice that isn’t limited to funds with a stated ESG strategy is advocacy and investment stewardship - which involves utilising share ownership to advocate for strong corporate governance on ESG-related issues. Primary activities include engaging with company boards and executives and voting on resolutions at annual general meetings. These efforts are aimed at ensuring companies disclose significant ESG risks, develop strategies to reduce them and report on progress - ultimately holding them accountable for practices that protect long-term shareholder value.

ESG integration

This more broadly defined method refers to a process where investment decisions are informed by an assessment of financially material ESG information. Primarily used by active fund managers to identify the risk or potential of a company, perhaps identifying an attractively priced and well performing energy company who is thoughtfully managing the transition to sustainable resources.

Exclusionary portfolio screening

As the name suggests, exclusionary screening involves excluding certain securities, industries or sectors from a broader investment. The exclusions are typically based on specific ESG criteria- for example, a global equities fund that excludes all companies that manufacture tobacco or weapons.

Inclusionary portfolio screening

On the flip side inclusionary screening, or proactive investment, directs investment towards companies that have higher ESG ratings relative to industry peers or other investment opportunities. Inclusionary investing could also involve targeting whole sectors that meet certain ESG criteria.

Impact investing

This strategy centres on targeting investments with dual objectives of supporting positive social or environmental outcomes while also generating a financial return. For example, a green bond where the proceeds are used to help the company make its manufacturing processes more energy efficient.

With an understanding of these approaches and their different applications, investors and advisers are equipped to consider ESG within a broader financial plan. In doing so ESG becomes a part of the process of weighing key investment considerations alongside other familiar fundamentals including goals, cost, diversification, risk and potential return.

Capable investment managers will continue to provide product options that address the increasing appetite for ESG investing, and while this could provide more options that reflect the diverse goals of investors more choice can bring a degree of complexity.

While investors will always benefit from carefully considering the available options, a product versus product comparison can never take the place of a clear understanding of how you want your own values and goals to be reflected in your investments.

 

Evan Reedman is Head of Product at Vanguard Australia, a sponsor of Firstlinks. This article is for general information and does not consider the circumstances of any individual.

For articles and papers from Vanguard, please click here.

 

7 Comments
G R
April 30, 2022

I wouldn’t be so fast to write off ESG investments, particularly with most of the wealthy developed world areas in America and Europe generally agreeing that there must be a transition ASAP to IPCC recommendations since COP26. There could definitely be a set back in global trade if China and others who have also signed up to COP26 then remain relentless polluters, but in the short term a reduction in global trade might be the only long term sustainable course.

Ray White
April 30, 2022

I can't help but think that, having read Tim Davis' excellent article above on the three waves of inflation, that ESG has little, if any, real influence on the emerging China side of the new axis where an overwhelming proportion of resources actually reside. Does ESG really matter, or even exist, in One Belt One Road initiatives? Looking at lived experience, including the Solomon Islands recent agreement, I doubt it.
So, ESG only matters to investors in the US axis, where private investors dither, while on the Chinese side, Government investors either don't let such niceties stand in the way or direct private businesses to do what they are told anyway
Thus, ESG is really a millstone dragging US axis while the Chinese axis steams ahead, undeterred by such minor and inconsequential matters
If you need convincing, Russia's actions in Ukraine and the fact that 39 countries abstained or voted against the recent UN vote to sanction Russia, a permanent member of the Security Council no less. And they only have 5% of the globe's entire external debt with the other 95% owed by, you guessed it, the US axis, us included. So debt does really matter
Now look at the oil graph; US 33%, China 67%. You might be aware that access to oil decided or tipped the outcomes of both World Wars in the last century. History repeats itself then, again?
So, ultimately I can only see us, as part of the ESG beholden US axis, being overtaken and made an irrelevant rump, or vassal state, of the China axis
Of course, we can protest our ESG demands, and continue to do so in some cell or gulag. No matter
The preponderance of ESG in assessments of Western financial transactions is simply making Western companies survival not only less likely, but their demise more timely, as the Chinese side roll over them
Globally, as things are now, we're stuffed..
And don't rely on your ESG concerns to keep you warm either. Your fate may well depend on it
* Data from T Davis Three Ways to Keep Inflation High Over the Next Decade

George Hamor
April 30, 2022

Agree completely with Ray's summation of the situation.
Democracies which allow free speech, woke views, the influence of shareholders who hold relatively small holdings in a company but are able to influence boards making major decisions based on feel-good policies, are up against non-democratic societies where the state makes decisions. Thus we wring our hands because of our puny emissions, yet give a free pass to China and the like to pollute as much as they like till 2060.
And anyone who believes China will then start to reduce their emissions is dreaming, unless it suits the state to do so.
The West is being played for fools by the totalitarian states; view Russia's invasion of a neighbouring country and all the West does is play nice.

Michael2
May 08, 2022

Just because it is written doesn’t mean it is correct

Allan Wilson
April 28, 2022

I always have a problem with the screening processes. Where does it start and stop. As an extreme example any company that operates in China is supporting a country with slave labour, still building coal fired power stations, jails people for dissent with no rights to a fair trial etc etc and therefore should be on the list of ESG excluded companies.
Instead we use a negative screening process to exclude a company that makes insulated glass for buildings because it uses power from coal completely missing the point that the glass they produce makes building far more efficient and reduces long term power consumption of said building as it reduces the need for a/c and/or heating.

Nick
April 28, 2022

ESG are essentially "stock pickers". We have been told many times that "stock pickers" underperform the market over the medium to long term. For best financial outcomes, investors would better off in a whole of market index fund.

Pete
April 28, 2022

ESG has political overtones. Who knows what the exact political objectives are of these fund managers. In the end they wield a lot of political power without being elected and only giving vague explanations of what they are doing. My suggestion is stay away from these people who would have you believe that they can solve the world's problems while they profit from creating this hype.

 

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