Sustainable Investing: The ABCs of ESG

“To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”

Larry Fink, Chairman and CEO of BlackRock, the world’s largest money management firm

Sustainable Investing (SI) is the general term used for considering the environmental, social, and governance (ESG)[1] impact of investing in the securities and assets of governments and corporations. Responsible investing, social investing, or values-based investing are other terms that are often used. Similar to traditional investing, it can be hard to filter SI information to separate the hype from the helpful.

The growth of SI is an exciting and positive development in the world of wealth management. Over the last few years, and particularly 2020, there has been rapid growth in investment dollars flowing into SI. The wealth industry knows a good trend when it sees one. It has predictably responded by creating a plethora of products such as exchange traded funds (ETFs). There are also multiple ESG data providers and sources to screen and measure companies and investments. My goal is to filter through the noise for you and focus on the basics or ABCs of ESG ETFs that you can use in your portfolio.

A is for Architecture and Acronyms

Your wealth strategy can range from the traditional focus on financial goals to being fully focused on social values. The hierarchy in Chart 1 categorizes SI’s increasing focus on social values, with philanthropy being the apex. It is important to note that this does not automatically mean that you sacrifice financial goals or potential returns. While the SI investment universe does get smaller, there is an argument that on a long-term horizon the best companies from an SI perspective may perform better or have less risk. I will leave that discussion for a future blog.

Chart 1

ESG

The ESG factors mentioned earlier are the starting level. ESG metrics and analytics are used to include higher rated investments into your portfolio. This can get confusing as there are several companies that provide the data. The challenge is that they use different ratings systems and can arrive at different results for the same company or investment! To try to simplify things, lets look at the top two providers: MSCI and Sustainalytics/Morningstar. Their ratings are available by clicking on the links below.

MSCI is the largest and most influential provider, and rates companies, mutual funds, and ETFs using the following scale:

Sustainalytics, which is owned by Morningstar, uses a numerical scale for rating the ESG risk of companies:

Morningstar uses the following rating system for ETFs based on data from Sustainalytics:

The best approach is to look at more than one rating for a company, fund, or ETF and the rationale behind the rating.

SRI

Socially responsible investing builds on ESG by using more active strategies. In addition to using ESG ratings and analysis, it creates more customized portfolios that screen out and exclude certain sectors, industries, and companies. It can screen to add in areas that have a positive impact. Common industries that are screened out are alcohol, firearms, fossil fuels, and tobacco.

Impact Investing

Often referred to as thematic investing, this is the most focused strategy. Impact investing hones-in on specific themes, sectors, or industries for a social or environmental impact. An example would be investing in a clean energy ETF.

B is for Benchmarks

Just as there are multiple providers of ESG ratings and analysis, there are multiple providers of equity and fixed income benchmark indices. The benchmarks are used to construct indexed ETF portfolios and to measure the performance of SI investment products and managers. By far the largest provider is MSCI. They have a bounty of benchmarks that cover various levels of implementing SI across countries, sectors, and industries. To give you a sense of how they work, let’s look at a subset of U.S. ESG benchmark indices in Chart 2.

Chart 2

The chart looks at three different MSCI U.S. stock market ESG indices, with the green boxes showing what they exclude. While the table doesn’t show all the criteria, you can see how the indices get “greener” as they exclude more areas. There are MSCI indices for Canada, the U.S., international developed markets, and emerging markets. More importantly, there are ETFs available that replicate these indices.

C is for Costs

Implementing SI can be simplified through using ETFs. In Canada, the main issuers are iShares, BMO and Vanguard. The most popular ETFs are low-cost and indexed to an ESG benchmark. Chart 3 below shows the fee range for Canadian and U.S. listed passive or indexed ESG ETFs. There are also asset allocation ESG ETFs that include the asset classes in Chart 3. On average, the lowest fee ESG ETFs cost less than 0.1% more than their non-ESG counterparts.

Chart 3

Moving up the SI Hierarchy

Looking at the Architecture and Acronyms you see that there are various levels of SI you can choose from. There are Benchmarks which measure varying degrees of SI implemented across countries, sectors, and industries. The Cost of implementing is small through low-fee ETFs. If you want your portfolio to do more than focus on financial goals, incorporating your social values has never been easier or cheaper by investing in ESG ETFs.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.

[1] Generally environmental factors are climate change, natural resources, pollution, waste, the treatment of animals, and environmental opportunities. Social factors are human capital, product liability, stakeholder opposition, and social opportunities. Governance factors are corporate governance and corporate behavior.