Gavin Smith
Institutional investors have always been keenly aware of their returns. Increasingly, however, they are also rightfully aware of the method in which these returns are being achieved and as a result, voicing their concerns about investing in companies that do not align with their values. The challenge, however, is balancing values-based investing ideals with achieving positive returns. This article discusses how institutional investors can do both: invest in line with their values and simultaneously beat the benchmark.
The Challenge
Historically, measuring the impact of public companies has been challenging due to the lack of reported data. To make matters worse, certain companies employ deceptive marketing practices to hoodwink investors into believing their products, services and policies are being offered in line with environmental, social and governance values–a practice known as greenwashing which has undoubtedly tarnished ESG’s reputation.
For these reasons, some investors have begun to view ESG investing with cynicism and are finding it difficult to not only invest with impact but do well without forfeiting returns.
The Solution
Despite the challenges, asset owners today have an opportunity like never before to “do well by doing good” by broadening their investment goals from risks and returns to incorporate approaches that help address increasing social and environmental challenges facing the world. To accomplish this, however, ESG alone is not enough.
A clear and transparent template is required to help define and identify products and services that positively impact the environment and society. The United Nations’ 17 Sustainable Development Goals represent a and can serve as a framework providing investors an intuitive approach for properly evaluating companies and avoiding greenwashing or cheating.
Aligning a company’s products and services with the SDGs to assess their impact on the world could be the basis for building custom SDG-focused portfolios in global equity markets. However, SDGs alone are also not enough.
The Need for SDGs and ESG
Before we continue, it is important to understand the differences between the UN’s SDG measurements and measurements of material ESG risk factors. While both insights are important when holistically evaluating a company, they are distinct.
Quite simply, SDGs can measure the impact of what a company produces, while analysis of material ESG risk factors can measure how a company produces its output. This external vs internal focus is important because while SDGs help identify companies with products that can positively impact the world and its citizens, an ESG risk focus on operational processes can identify both a company’s financial risks along with activities that could have harmful consequences for the environment and society.
The combination of these powerful signals leads to broader and more transparent insight into the impact of a company’s products and services as well as whether its operations are conducted in a clean, fair, and beneficial way. Using this double-barreled insight, companies with impactful products that are responsibly manufactured can be identified and investors can build portfolios that align with both their investment- and impact-based goals.
The Approach: Customization and Identifying Attractive Impact Investments and Building Custom SDG Solutions
While combining SDGs and ESG sounds good idealistically, the question quickly becomes how investors can put this approach into practice and identify companies with a positive impact and return profile. The answer is by following the market.
Changing consumer preferences and demand, which have driven companies to provide more impactful and responsible products and services, have also led asset owners to increasingly search for investments that intersect upside returns and sustainability. This shifting demand trend is a tremendous secular growth opportunity for companies and one that not only underscores how contributing to the progress on SDGs is important for society, but how doing so can also benefit a company’s returns.
Until recently, it was a burden for investors to identify companies that made a positive impact and were also attractive from an investment perspective. However, by using carefully chosen and constructed factors, we can assess performance potential while focusing on overall sustainability impact. However, it is important for investors to understand two things:
First, the tradeoff between risk and sustainability necessitates advanced portfolio engineering. The frontier of portfolio outcomes varies between a simplistic (passive) portfolio that offers no risk, but also no exposure to sustainability, to a fully sustainable portfolio that is simply unacceptable from a risk perspective.
Second, and most important, customization is required. No two asset owners have the same view about which areas of sustainability they want to focus on and as such, they should not be forced into cookie-cutter strategies. The ability to customize which SDGs are targeted in a portfolio (and therefore what impact is achieved) is critical, along with considerations such as geographic regions, market cap size, and the target index.
Asset owners are unique in their investment goals and desires, and therefore require unique solutions that can help complete sustainability exposures across their broader equity allocations.
In the end, when it comes to values-based investing, there is a lot of noise to sift through and data to digest. But by building a customized portfolio based on ESG and SDG principles, investors can truly invest with impact without sacrificing returns.
Gavin Smith is head of equity research and sustainable investing at PGIM Quantitative Solutions.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.
Tags: environmental social and governance investing, ESG, investment returns, UN Sustainable Development Goals