ESG vs SRI
There is a growing desire among young investors to have their investments not only provide returns, but to support their views on environmental and social issues. That is where ESG and SRI come into play which can be confusing as they are often used almost interchangeably, which is not the case. So, let’s dig into these terms to see what they mean, how they work in practice, and some thoughts to consider as you make a decision to use any of these methods.
ESG stands for Environmental, Social, and Governance practices of a certain investment that may have an impact on the returns of that investment. These factors are employed to add depth to the traditional financial analysis by attempting to uncover deeper risks and opportunities that don’t show up in normal valuations. Environmental, social, and governance cover quite a range of issues, so here are some examples of the filters applied in each category.
Environmental- Climate change, pollution, protection of natural resources, animal welfare, and waste production.
Social- Human rights, child labor, community engagement, and health and safety.
Governance- Quality of governance, independence of the board of directors, shareholder rights, conflicts of interest, and executive compensation.
While there is certainly an emphasis on supporting companies that do good for society, the main objective is still to generate returns for investors. Now that we have a better understanding of how ESG investing works, it is time to look at the risks and benefits.
There are risks and benefits to every investment strategy and anyone who tells you that they have an investment with huge upside and no risk is trying to sell you something (usually it’s a whole life insurance plan somehow). First, the benefits that ESG offers can be coalesced into two basic points, the capitalist point of view and the priority point of view. The capitalist point takes the view that ESG filters can be used to screen for socially ethical business as they believe that those companies will generate positive long term returns. This is simply the belief that companies who do good will do well. This viewpoint is pretty easy to measure as it is determined by how much returns the company or companies generate. When choosing which ESG funds or companies to support, make sure you’re looking at if this bears fruit in order to get the most out of your investment. The priority argument is far simpler in that you as a person have the option to put your money where you believe it will do the most good while still generating returns. Are you willing to generate potentially less returns in order to avoid companies that don’t have societies’ best interests at heart?
Now that we have seen the reasons to dive into ESG, there are some reasons to be hesitant as well. The capitalist point of view says that companies that do good will do well which is great, however it hasn’t exactly always been true. The research on this topic is inconclusive at best and certainly is not helped by the sheer amount of funds and methodologies claiming ESG services. Another issue is that companies and ESG methodologies will evolve and doing the research to make sure a company still fits in the ESG filter isn’t free. This means that the ESG fund or portfolio will have to beat the non-ESG benchmark by an amount that covers the cost of the research, monitoring, and rebalancing.
The counter to the priority argument is fairly simple. If an ESG fund returns less after fees than a non-ESG fund, would it be better to take the money earned by not choosing an ESG fund and spend it on philanthropic cases you care about? With ESG it provides you a wide range of companies that do good, but if you care about a few issues deeply, it may be better to take the extra money earned and devote it towards organizations that deal those issues. Just like using ESG because that’s where your priorities lie, this is a decision that only you can make.
Moving on to SRI which stands for Socially Responsible Investing, this takes ESG to a different level in terms of screening for companies that do good. While ESG investing applies a new level of analysis to valuations, SRI focuses on a values mandate. These values can be wide ranging, but typically exclude a portion of the investment universe in order to satisfy the values being implemented. For example, you have no interest in supporting companies who produce guns or tobacco products. This is a case where SRI comes into play over ESG as they will exclude all companies, funds, or ETFs that carry companies that produce firearms or tobacco. This can also work with positive filters, where companies that support charitable causes or other socially positive actions.
We can see how SRI is different in practice than ESG, but what about the actual financial side of things? Well, ESG is a valuation tool but the goal is absolutely to generate the most returns possible. The main thrust of SRI is to create an investment that conforms to the social conscience of the investor, and then trying to get the best returns. This adds a new wrinkle to the decision-making process of whether to choose ESG, SRI, or go without these filters. As I mentioned when discussing ESG, is it better to pursue higher returns and then use the extra earnings to fund the causes you care about, pursue a broad valuation strategy like ESG, or eliminate aspects you want nothing to do with while potentially taking a hit on your investment returns?
I know this is a lot of information and it’s only barely scratching the surface of the complexities of SRI or ESG investing. The main point to remember about ESG/SRI is that ESG mostly focuses on valuing companies whereas SRI focuses on a values mandate. These decisions are not easy as money can complicate everything and you must take a hard look at which priorities weigh the heaviest. If you do want to walk through the decision making process or have further questions about specific aspects of SRI or ESG investing, please reach out to me and we will set up a time to chat.