Once considered a niche market within the investment universe, strategies that integrate environmental, social and governance (ESG) concerns into their investment process have hit the mainstream.
This has been driven by several social movements and the recognition that there is still a great deal of work to be done, particularly from a financial standpoint, to address issues ranging from climate change and gender equality to indigenous rights.
Investors who are just beginning to incorporate ESG elements in their portfolio may prefer a passive strategy for a few reasons.
First, a passive approach may offer exposure to a broad large cap segment in the market, which might make it suitable as a core portfolio holding.
Second, you get a level of transparency into which ESG elements are being incorporated alongside the other financial considerations for building the portfolio.
For an ETF, the rules are transparent and public, so the investor can evaluate the strategy before buying into it.
The ESG journey
Once investors have made that first portfolio allocation into an ESG strategy, they may choose to take positions in vehicles with more active, engaged ownership. That may be in the form of a traditional actively managed fund, or through a separately managed account.
Investors may seek to complement their core equity holding with a fixed income mandate that’s also addressing ESG issues within the debt market.
ESG by asset class
Incorporating ESG factors into the investment analysis process can help to identify certain risks more easily, particularly in a company’s governance. Consideration of such factors occurs on a spectrum and can be included in fundamental analysis for any holding.
It’s not foolproof, but ESG strategies integrate a new set of data points into corporate evaluation, with the goal of better identifying unpriced risk.
There’s also a difference in how risk can be evaluated through the ESG lens, depending on the asset class.
With equities, risk often expresses itself through scandals or environmental catastrophes. In these cases, ESG indicators may not be predictive because the available data tends to be backward-looking. For example, improper accounting practices may mask a governance problem until an accounting scandal is unearthed.
With fixed income, ESG indicators may be somewhat more predictive of the long-term ability of an issuer to service its debt. If a company has strong governance structures in place, has minimal exposure to environmental risk, has good employee relations, they should face less disruption than a company without these characteristics.