We already know there are a growing number of socially-focused investors pushing for more choice and control over their investments.
Interest in ESG in Australia is healthy and growing, even as measured against global trends (of $30 trillion invested in ESG globally, $980 billion is allocated in Australia) and the events of 2020 have only compounded those preferences.
The bushfires over the Australian summer followed shortly after by the COVID-19 pandemic have sparked a renewed interest in environmental, social and governance (ESG) issues.
With more and more public companies now disclosing their ESG indicators, investors are getting the benefit of ESG-related data moving from the margins to the mainstream.
The upshot of that has meant socially-minded investors now have a much wider choice of ESG investment choices, both active and index, and asset managers are now integrating a wider field of ESG indicators into investment options.
The increased availability of ESG data has enabled index providers like Vanguard to construct and offer a wider set of screened indexes capable of meeting different preferences for different socially-minded investors.
How to make sense of increasing choice
With the choices for ESG investors increasing what – if anything – should investors do about integrating ESG into their portfolio and how should they approach narrowing the field of choice?
Promoting good governance practices, protecting the environment and engaging in climate risk mitigation are top-of-mind for an increasing number of investors. Even so, it can be particularly hard to make a call on how to select investments reflecting those concerns if you’re making choices on behalf of clients or beneficiaries.
Deciding a course of action when there are multiple parties or stakeholders involved, as with investment committees, can be complicated.
Many ESG investing approaches are available, and deciding which tool, or set of tools, to use – if any – depends on a variety of factors.
To assist in making informed ESG investment choices that reflect an investor or investors’ socially-minded goals, Vanguard has developed a framework to help focus the search:
Figure 1: Key steps to making a prudent ESG investment decision1
Just as with the principles for long-term investing success, the framework asks investors to first define the goals of your ESG investing activity. From there, evaluating your options and choices is key before deciding on a course of action. A prudent approach to ESG investing also asks investors to periodically monitor and review your decisions to ensure they stay relevant and on-target towards your original goals.
1. Define goals
What ESG issues matter?
First establish what you aim to achieve through ESG investing. Investors list of potential ESG-related issues is typically as diverse as it is long; animal testing; weapons; board diversity; human rights standards; opioids, tobacco, privacy – the list goes on.
Fossil fuels is one of many issues that demonstrates how caring about an ESG issue does not necessarily easily or directly translate into a clear choice of companies or investments.
Investors who want to adopt a screening approach to fossil fuels – wanting to screen out companies that exhibit that undesired ESG behaviour – may become confused about at which point to ‘draw-the-line’ on their beliefs when it applies across the whole supply chain: is it at the point of initial exploration? What about end consumers and activities like aviation and driving? Determining the boundaries of an ESG issue can be a complex, involved process.
Questions inevitably arise in a more detailed discussion of beliefs of what an investor screens in or out. Ideally, it would be as clear as possible about what they will or won’t tolerate as part of their goal-setting. Objectives are important in defining these goals.
It’s common for investors to have one or more of the following reasons or objectives for deciding to invest in ESG. Whether to:
- Satisfy values preferences;
- Generate financial benefit such as risk-adjusted return;
- Effect meaningful change on an issue that concerns them;
- Meet legal requirement. For instance, a regulatory change may require a pension fund to exclude investment in companies that conduct certain activities.
2. Evaluate options
Social impact bonds. Green bonds. Norms-based screening. ESG Integration. Impact Investing. There are a wide variety of terms and approaches. And just as much as the terminology has proliferated so too has investor confusion. For investors grappling with whether they should do anything about ESG within their portfolios, Vanguard believes investors need to address the ESG-related goal or set of goals.
Vanguard’s ESG funds primarily employ an index investing approach. These index funds use exclusionary investing strategies, which means they avoid investing in companies that engage in certain business activities, such as the production of fossil fuels, weapons, or tobacco. These funds may also exclude the stocks of companies that fail to meet certain standards for environmental, labor, human rights, diversity, or anticorruption practices.
3. Decide on action
While there can be no singular “best” ESG strategy, the field of choice can be better tailored to investors’ preferences by following the previous steps.
Begin by setting goals, review and identify the field of potential investment options available and then deciding on a course of action.
For those serving as fiduciaries, it’s important at this point that the decision-making process is clearly documented.
This means engaging in some procedural due diligence to ensure that stakeholders – whether client, legal counsel or regulator – have a clear view of any decision-making. If a stakeholder later requests information about a decision, ideally there would be documentation in which the goals and expectations of a course of action are clear.
4. Reassess periodically
As with any investment decision, the last step to rounding out a prudent investment decision is to periodically monitor and reassess whether it’s tracking to your objectives.
For institutional investors, this step may require some form of legal document, with varying levels of detail to ensure that proper assessments and stakeholder reporting become a standard practice. If action was taken, the evaluation should be linked to the goals and the criteria used, along with any metrics to be tracked or tasks to be done to measure success.
Putting it all together
Figure 2 presents a more detailed summary of the four primary steps to making an informed decision about ESG investing. The aim of using this framework to assess ESG investing is that investors will have identified their goals, assessed an array of potential courses of action, and made a choice supported by thoughtful evaluation of important considerations and trade-offs tied to their preferences, beliefs, expertise and circumstances.
Figure 2: Making informed decisions on ESG investing actions2.
Is it time to revisit the way you invest your money? Book a time to chat here and let’s discuss what’s best for you.
1. Source: ‘ESG, SRI, and impact investing: a primer for decision-making,’ Vanguard Research, Douglas M. Grim and Daniel B. Berkowitz, August, 2018, Figure 8 on p. 8 of 27.
2. Source: ‘ESG, SRI, and impact investing: a primer for decision-making,’ Vanguard Research, Douglas M. Grim and Daniel B. Berkowitz, August, 2018, Figure 8 on p. 18 of 27.