Imagine you're buying a home. You research mortgage interest rates, comparable prices in the area and your realtor walks you through a home you're interested in. But only half the doors are open.
Are you willing to buy it? For most, the answer is no. You want to see the rest of the rooms, check out the décor, lighting and layout. Make sure there isn't mold, leaky pipes or other skeletons hiding behind those doors. All of these factors are essential to assessing the value of that house for you and your family.
Investors should do the same thing—consider as much information as possible—when they buy and sell other assets. If you are looking at buying stock in a soda company, for example, last year's sales and the company's debt load are important information to consider. However, the company's future profits and stock prices can also be impacted by how much water that company uses and if it comes from water-stressed areas. Similarly, if you're looking to buy an internet stock, you would want to know if the company has ever been found guilty of misusing personal information, because any potential fines may impact their bottom line.
These examples use environmental, social or governance (ESG) data points that are material to a company's overall financial performance to make investment decisions. Unfortunately, misinformation around what ESG is has sparked increased politicization that could ultimately limit investors' choices on how they construct their portfolio.
ESG doesn't have to be a polarizing investment strategy
So, why is there so much uncertainty around ESG? The short answer: When people talk about ESG, they most likely mean different things.
Investors, journalists and politicians use that one broad term—ESG—to mean different ways to apply environmental, social or governance data in investing. That confusion has sparked legislation in several states and even Congress to ban ESG use in investments, making the investment strategy even more polarizing in the public's eye.
It doesn't need to be that way.
We use the umbrella term “responsible investing," which can be used to define how you can use environmental, social and governance data in an investment portfolio. There are four distinct applications of this data:
Systematically incorporating material ESG factors into investment decision making to help identify potential risks and opportunities and help improve long-term, risk-adjusted returns.
Applying positive or negative screens to include or exclude assets from the investment universe.
Investing in assets involved in a particular ESG-related theme or seeking to address a specific social or environmental issue.
Investing in assets that intend to generate a measurable positive social or environmental impact.
ESG integration—taking the politics out
When applying the ESG integration approach, as outlined above, it's not about a company's end product. It's not about the can of soda. What is considered is how that can of soda is made, how it's marketed and if the company invests in wastewater recycling.
It's not only about ad revenue for the internet company, but also your personal information that they collect and how they use it. Just like finding black mold in the basement could affect a home's value, those extra factors might be overlooked even though they may impact the company's bottom line and a client's potential investments.
Selecting investments by applying the ESG integration approach involves using nonfinancial information that could impact the company's future earnings, alongside financial information to inform your choices.
Investors have many competing priorities when deciding how to construct their investment portfolio. What are your goals? What level of returns do you need to get there? What level of risk are you willing to take to achieve these returns?
Integration of ESG data into an investment process makes sense as you build portfolios. And a well-trained investment analyst will know what data to look for and how to use it.
Integration is an apolitical, agnostic approach to help clients achieve their desired financial outcomes. Investors should be allowed to consider this information. Banning ESG applications could pose a material risk and hurt financial performance for investors by limiting the information they can use to make their own choices.
This article was originally published in MarketWatch