As described in our Introduction to ESG Investing, ESG refers to environmental, social, and governance factors that can be integrated into portfolios alongside traditional financial metrics. In that post, we covered the origins of ESG investing, an overview of the current state of ESG investing, and why investors believe ESG metrics are important to understand. Here we’ll explore the mechanics behind ESG investing and how these principles are integrated into a portfolio.
How are ESG Standards Determined?
One common way to access ESG investments is to invest with a manager through a mutual fund, exchange-traded fund (ETF), or separately managed account (SMA). It is the manager’s responsibility to assess the ESG credentials of each company being considered for the portfolio and determine if each company meets the fund’s stated ESG standards. Managers use data reported by companies to understand whether or not a company meets their standards, which is reported alongside traditional financial data points in annual reports or impact reports. Companies are not required to report ESG data, so it is important for managers to differentiate between financially material data and “greenwashed” data that’s designed to make the company look good but may not actually reflect strong ESG performance.
Once ESG information is reported by companies, it is gathered by data aggregators and analyzed to assess the ESG quality of any given company. Each ESG data aggregator, or vendor, has its own process for collecting and scoring the data reported by companies. Since ESG analysis relies significantly on subjective judgments – for example, by assessing and weighting which factors are most relevant to a given company – it is key to aggregate data from multiple sources instead of accepting data from one vendor as fact. This is similar to seeking a second opinion from another doctor when getting a medical diagnosis. More sophisticated managers also layer their own proprietary ESG framework on top of third party data to ensure each company is being scored consistently, meaning they can be properly compared across both fundamental and ESG metrics.
What is the Difference Between Positive and Negative Screening Strategies?
Investors looking to integrate ESG into their portfolio have a variety of options to choose from. The simplest way of applying ESG is through negative screening, which means to exclude companies or industries not suitable for an ESG portfolio. These exclusions can be based on overall ESG assessment or on specific ESG metrics, such as carbon emissions, the diversity of a company’s leadership, or the number of independent board members. A negative screen could either result in a full divestment from a company or an underweighting of the company relative to a benchmark.
The opposite of negative screening is positive screening, or positive tilting. This portfolio construction goes beyond the exclusion of ESG laggards to specifically include or overweights companies with strong ESG credentials. ESG leaders can be identified on either an absolute or relative basis. Absolute standards means the manager selects the strongest companies overall, regardless of industry or sector. Relative standards, on the other hand, identify the top ESG performers within a given asset class, sector, or part of the market, to create a “best in class” portfolio.
ESG integration can apply to both active and passive portfolios. In a passive portfolio, the manager would systematically exclude companies that don’t meet the manager’s ESG criteria, and weight the remaining companies based on their ESG “scores”. Alternatively, an active manager would analyze each company in depth and hand-select the strongest companies based on their ESG assessment.
Can You Use Your Portfolio to Target a Specific Impact Area?
Managers may choose to target specific impact or ESG areas such as low carbon, gender lens, or SDG themes. This is referred to as Thematic investing.
Thematic investing can use both negative and positive screening tools, active management and company selection, or a combination of all these tools to target specific impact areas. For example, a low carbon portfolio might screen out companies with the highest carbon intensity and owners of fossil fuel reserves, while overweighting companies with low carbon intensity. A gender lens theme may require a certain level of gender diversity on the board or management for consideration to the portfolio. A United Nations Sustainable Development Goals (SDG) themed portfolio would likely invest with companies whose products and services target specific SDG themes like clean energy production or financial services focusing on underbanked populations. Thematic investing in public markets can also be actively or passively managed; active managers hand-select companies that fit a particular theme, while passive managers quantify companies’ exposure to a particular theme and systematically assess and select the most appropriate companies for the portfolio.
Not only are there different ways to invest in ESG regarding screens, tilts, frameworks, and themes, but these strategies can be applied to different asset classes, such as equities like stocks and fixed income like bonds. These two asset classes are very different in nature – owning stock is general ownership in an entire company, while purchasing a bond is providing liquidity (lending) to a company for a specific purpose. Stocks are assessed by the management of operational ESG factors or by the impact of the company’s products and services, while bonds are assessed by the ESG profile of the issuer or by the impact of the project that the issuance is funding. For example, if an investor wants to contribute only to educational infrastructure in a given school district, they may be able to purchase a bond issued by the municipality to build directly a new building for that school. However, it would be more difficult to invest in that level of targeted exposure through equities. For these reasons, bonds may be more or less appropriate to achieve certain ESG goals.
Overall, integrating ESG into a public market portfolio is fairly accessible to all investors. Investors should mindfully prioritize their goals and values and then find investment approaches and managers who can provide solutions aligned with those principles.
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