By: João Guimarães
When you think of making the world a better place, investing may not be the first idea that comes to mind. Words like volunteering, donating, and recycling are likely to pop up first. But what about our portfolios? Are there ways for us to make a positive impact with our investments? Welcome to the complex world of values-based investing.
As we experience the devastating effects of climate change, and social issues such as racial and gender inequality, a growing number of investors are shifting their capital to address these systemic challenges. Hence, the recent growth in demand for values-based investing.
While values-based investing has gained in popularity over recent years, there is still apparent confusion about the different strategies and approaches. Terms such as SRI, ESG, and impact investing are often thrown around and used interchangeably by small investors and professionals alike, yet there are distinct differences between them. The lack of clarity around these terms poses a serious challenge to individuals looking for the investment best suited to their goals. So, let’s begin at the beginning. We will take a look at what these terms mean, some of the pros and cons, and what WCF is doing or making available to our clients in these areas.
Socially Responsible Investing (SRI)
SRI entails screening investments to actively eliminate or actively include investments according to specific personal values or guidelines. For example, avoiding investments in “sin stocks” that generate profits through controversial activities like alcohol, tobacco, gambling, or guns.
SRI may help you sleep better at night knowing you’re not invested in companies involved in unethical causes and you’re supporting companies that are doing more to enact change. It feels good to see your portfolio flourish, but it might feel even better if you knew that the revenue sources and business practices of the companies you are invested in are not misaligned with your values.
Screening investments based on personal values can have an impact on the level of diversification of your portfolio. For example, environmentally conscious investors might have an under-exposure to fossil fuels and an over-exposure to companies without many tangible assets.
Many investors engaging in SRI do so by investing in mutual funds that follow socially conscious strategies. These funds tend to charge higher fees than simpler strategies with similar expected risk and return characteristics.
What is WCF doing in this space?
WCF currently excludes guns, tobacco, and managed healthcare from all managed investments. Additionally, we exclude other companies/sectors upon request.
WCF also offers a “fossil-fuel free” portfolio composed of diversified mutual funds. These can be used as a standalone allocation or as substitutes for indexes. For example, replacing exposure to the S&P 500 index with an S&P 500 fossil fuel free fund.
Environmental, Social, Governance (ESG) Investing
ESG investing, as defined by the CFA society, is an approach to managing assets in which investors explicitly incorporate environmental, social, and governance factors in their investment decisions with the long-term return of an investment portfolio in mind. Specifically, environmental factors focus on the conservation of the natural world, social factors examine how a company treats people both inside and outside of the firm, and governance factors examine how a company is run.
Investors pursuing an ESG-based strategy take these factors into account and rate companies on a wide range of ESG topics. The goal is to consider these ESG ratings alongside other traditional financial factors to maximize financial returns or minimize risk. Differently from SRI, which is focused on whether a company’s practices are in line with an individual’s values, ESG investing focuses on how these practices may impact its profitability, risk, and return.
ESG investing aims to reduce portfolio risk and volatility by investing in companies that are more effective in evaluating and managing ESG risk factors. For example, an oil company that invests more time and resources to improve safety measures and to evaluate environmental risks may reduce its chances of suffering a costly oil spill.
In addition to reducing downside risk, an investor may believe ESG investing can also offer higher returns than traditional investing strategies. Examples of potential drivers of higher returns could be: increased efficiency, reducing the probability of fines, and improved employee satisfaction and productivity, to name a few.
One major challenge to ESG investing is that it’s very difficult for individual investors to measure companies’ ESG performance, so investors tend to rely on ESG rating agencies for insight into how companies are performing in each ESG area. Because there is not yet (and may never be!) a universal measurement of ESG performance, there is significant inconsistency in the major ESG ratings. It’s important to note that many of the popular companies providing these ratings suffer from a dearth of data on smaller companies and certain sectors and geographies. This leaves investors uncertain of which ratings can be relied upon, which in turn impairs their ability to use ESG data in their investment decision-making process.
Another issue is the practice of “greenwashing”, which is the use of misleading claims about the sustainability of an investment product. This is often seen in mutual funds that market themselves as “sustainable” but are invested in companies that aren’t aligned with the values a reasonable investor would expect based on their name.
What is WCF doing?
WCF offers an ESG portfolio composed of mutual funds invested in three different equity asset classes (large-cap US, small-cap US, and international stocks). To avoid “greenwashing”, these funds were chosen following a rigorous vetting process with a particular focus on how clear and transparent each fund is about their investment process and how they describe their relationship to ESG.
Impact investing is an investment strategy that intends to positively address social and environmental challenges while expecting to generate positive financial returns. There are a few major differences between impact investing and the other values-based investing strategies.
First, impact investing (as typically used and as we define it) refers to private funds, while SRI and ESG refer to investments in public assets. Apart from that, there are two factors that set impact investing apart: intentionality and measurement.
Differently from ESG investing, impact investing is not so much focused on financial returns as it is on the social and environmental outcomes of an investment. The investor must intend to make a positive impact with the investments, and financial returns are a secondary priority.
There must also be a commitment from the investee to measure and report on the environmental and social impacts of that investment. Examples include the number of affordable housing units built, amount of people benefitting from clean water projects, or a reduction of the carbon footprint by ‘x’ units.
Impact investing allows investors to prioritize their goal of making a positive impact on the world. This comes both from the intentionality aspect of this strategy and from its private nature. While public companies have an ultimate mandate to generate shareholder value through stock price appreciation, private companies have more flexibility in the ways they deploy their capital and determine their overarching goals.
This strategy is enticing for investors who seek transparency into the specific ways their capital is being used. Impact investing funds will release periodic reports summarizing the portfolio investments and highlighting key environmental and social impact achievements.
Because financial returns aren’t the main priority, these investments can carry a significant risk and may yield below-market returns. Impact investing funds may have higher costs than traditional funds because of their more rigorous due diligence process and their commitment to measuring their environmental and social impact.
The private nature of these investments means they are highly illiquid, which makes them less accessible than publicly traded options. Investors are usually faced with high minimum investment requirements and most are only open to institutional or accredited investors.
What is WCF doing?
WCF has partnered with New Summit Investments to offer clients the opportunity to invest in this space. This is a fund that pulls together many of the top impact funds (a fund of funds), which increases accessibility by offering much lower investment minimums. A few examples are investments in affordable housing, investments in organic food, and investments in battery recycling technology. We are also conducting ongoing evaluation of new investment opportunities in this space and are happy to review funds on an ad hoc basis upon request from clients.
As you can see, there are a number of ways to approach values-based investing. When deciding which approach is best suited for you, it’s important to consider the values you want to prioritize in your portfolio and the goals you want to accomplish with your investments. Are there categories of companies you wish to exclude? Are you looking to generate competitive returns without violating your principles and values? Are you willing to prioritize social and environmental impact over financial returns? These are important questions to ask yourself when choosing an investment plan that is right for you.
It is also important to consider the limitations of each of these strategies and to acknowledge their potential risks. WCF’s “fossil-fuel free” and ESG portfolios, as well as the impact investing funds we partner with, are different from WCF’s “primary” portfolio in that they are not managed to be first and foremost optimal from a risk/return perspective. If your primary focus is on achieving risk-adjusted investment returns, we believe WCF’s primary portfolio continues to be the best option we offer. However, if you are looking to prioritize your values and support companies aligned with your social responsibility and environmental standards, we believe these values-based investing strategies are a great way for you to have a positive impact with your investments while generating financial returns.