Not All ESG Funds Are Created Equal

Kali Hassinger Contributed by: Kali Hassinger, CFP®, CDFA®

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If you’ve read last week’s ESG blog, you should be familiar with the basic ideas driving ESG investing and aware of the recent investor rush to ESG investment funds.  Although 2020 was full of unforeseen circumstances, the trend to Sustainable and Responsible Investing has been building over many years. 

In the past, ESG was often used interchangeably with SRI, or Sustainable and Responsible Investing.  In reality, they are not exactly one in the same.  ESG analysis creates a set of standards used to screen investments through Environmental, Social, and Governance criteria.  Almost all Sustainable and Responsible strategies use at least one of the E, S, or G factors within their analysis, which is perhaps why the ESG abbreviation seems to have taken hold in recent years.  However, there are four prominent Sustainable and Responsible Investment approaches that are most often used to develop a portfolio or mutual fund.

Best-In-Class (Positive) Screening

This strategy involves investing in companies or sectors that have the best, or most positive, ESG performance relative to their peers.  The hope is that the investments selected in a best-in-class process will be able to handle unexpected changes regardless of the industry.  However, one criticism is that this includes all industries and sectors, often incorporating gas, oil, and mining companies, as long as they are handling ESG factors better than their peers.  Some refer to this as the “least bad” approach, as opposed to the best.  This is a good option for those who are afraid to miss out on returns by removing investments due to ESG factors.

Exclusionary Integration

Negative screening is what many so often associate with ESG investing.  This is most likely because it one of the oldest screening approaches and was often guided by religious beliefs with the investments eliminated through this process often referred to as “sin” stocks.  This approach, however, has evolved over the years to be less explicitly aligned with religions.  Now, exclusionary screens work to avoid companies based on more ESG related factors, such as fossil fuels, animal cruelty, and weapons production.  This approach is appropriate for investors who have specific ethical or religious motivations and want to be sure that their money is invested in a way that aligns with their beliefs.

ESG Integration

The ESG Integration approach involves using environmental, social, and governance factors to make decisions within a traditional financial analysis process. This approach does not prohibit investments in any particular sector or industry, and it searches to find value and opportunities by combining ESG information with conventional financial information. This method can include companies who have historically performed poorly in relation to ESG factors but who are working to improve on an environmental, social, or governance issue.  Notice the usage of OR in the last sentence.  This means that companies do not need to score or screen well in all three factors to be included or considered within an ESG integration fund.  This flexibility provides a vast investment universe and can be more palatable for investors who are still skeptical of ESG investing.

Sustainability-Themed Investing

Sustainability-themed investing often develops a portfolio aimed at solving a specific environmental or sustainable issue.  Within the selected theme, such as clean technology, climate change, animal welfare, or green energy, analysts will work to determine the strongest companies who positively represent this issue.  This allows investors to focus their resources on specific trends and to invest in companies who reflect those same beliefs in their business practices.

Although we have discussed these approaches as four separate methodologies, in reality, most ESG mutual funds use a combination of several or all of these tactics to build their portfolio.  This combination, which less frequently excludes specific industries or companies than it has the past, allows for more flexibility, which can translate to more opportunity for investors.  Many believe that companies who are focusing energy and time on ESG factors will be more poised for future success.  Are you interested to know how The Center develops and manages our ESG strategies?  Jaclyn Jackson, CAP® our firm Portfolio Manager will provide some insight next week!

Kali Hassinger, CFP®, CDFA® is a CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® She has more than a decade of financial planning and insurance industry experience.

Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Sustainable/Socially Responsible Investing (SRI) considers qualitative environmental, social and corporate governance, also known as ESG criteria, which may be subjective in nature. There are additional risks associated with Sustainable/Socially Responsible Investing (SRI), including limited diversification and the potential for increased volatility. There is no guarantee that SRI products or strategies will produce returns similar to traditional investments. Because SRI criteria exclude certain securities/products for non-financial reasons, utilizing an SRI investment strategy may result in investment returns that may be lower or higher than if decisions were based solely on investment considerations. Investors should consult their investment professional prior to making an investment decision.

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