By Bryan Carr, Sr. Research Analyst
Earth Day 2022 : Let’s Talk About ESG
Happy Earth Day from Pacific Portfolio! On this day, created to raise awareness about environmental issues, we reflect on how the choices we make affect the environment. There are many decisions we make every day to reduce our impact on the environment: recycling, buying organic produce, switching to a hybrid or all-electric vehicle, but did you know there are also decisions you can make about how you INVEST that can also reduce your environmental impact? At Pacific Portfolio, we believe that investment advice can not only be tailored to each client’s financial goals, but can also include a focus on values, and the two don’t necessarily have to be at odds. That’s where ESG & Socially Responsible Investing comes in.
ESG is quite the hot topic right now, but there is understandably some confusion around what the term ESG actually means, and depending on who you ask you might get different answers, so a little confusion is natural. So what does it all mean?
To start, ESG is a broad term that encompasses the many ways in which investors can take Environmental, Social, and Governance issues into account when building investment portfolios. ESG investments fall broadly into three basic categories: Negative Screening, ESG Integration, and Impact Investing. Understanding the differences between these three categories is crucial to choosing the investments that are right for you.
Negative Screening
Among investors who have been in the business for a long time, there is often an idea that ESG means excluding (or “screening”) certain types of stocks from a portfolio. These screens have historically excluded “sin” stocks (like tobacco, alcohol, and gambling), fossil fuel stocks, and stocks of defense companies to name a few. This type of investment mandate gained popularity in the 1980s and 1990s. As one would expect when using a screening process that excludes entire industries from a portfolio, they sometimes struggled to keep up with a broad equity benchmark like the S&P 500, forcing investors to choose between “doing good” and “doing well”. These types of portfolios still exist, but only represent a fraction of the ESG landscape today. They’ve largely fallen out of popular use in favor of ESG Integration.
ESG Integration
In recent years, when people talk about ESG, they’re usually referring to the process of “ESG analysis” or “ESG integration”. ESG Integration views Environmental, Social, and Governance factors as risks and opportunities that companies are exposed to. Portfolio managers then use these factors to augment traditional financial analysis when picking stocks for an investment portfolio.
As you can imagine, not all ESG factors apply to all companies. For example, a social media company like Facebook might not be particularly vulnerable to Environmental risks like Climate Change or Habitat Destruction, but perhaps an oil company like Exxon is. Data Security, a common Governance factor, might not apply very strongly to a food company like Tyson Foods, but for a software company like Microsoft it might be a huge factor.
Many portfolio managers have begun using ESG Integration to enhance their risk management by buying the stocks of firms who are doing a good job managing ESG risks and excluding firms who aren’t. There are also many Socially Responsible investment firms who are taking it a step further. These sustainability-focused funds are using ESG Integration to align their portfolios with their clients’ values and achieve returns that can compete with non-ESG and non-Sustainable funds.
These so-called Socially Responsible Investments add companies to their portfolios who are doing a good job on things like reducing their carbon footprint, fostering management and board diversity, LGBTQ+ issues, and using ethical supply chains, among other issues. They also exclude firms who perform poorly by these ESG measures. They also implement a process known as Active Ownership to improve the ESG performance of portfolio companies.
Active Ownership is when shareholders of a company engage with the companies that they own, meeting with management to provide expertise and engagement on how to improve on ESG issues. They also join with other Socially Responsible investors to propose shareholder resolutions which can improve board diversity, enact fairer executive pay, and mandate greenhouse gas emission and carbon footprint reporting.
ESG Integration combined with Active Ownership can allow investors to “do good” while “doing well”.
There are almost as many types of ESG and Sustainable funds as there are ESG and Sustainability issues. Many engage on a broad range of ESG issues all at once, while some are focused on addressing specific issues such as gender or racial equity, carbon and climate change, or renewable energy. These focused funds, called “Thematic” funds, capitalize on long-term trends and try to move the needle on a narrowly defined theme.
What if you want to make a more substantive, direct impact on Sustainability issues than is possible using the public markets?
Impact Investments
Impact Investments are investments made with the intention to generate a specific positive, measurable social and environmental impact while generating a financial return. The issues addressed by Impact Investing are quite diverse, from sustainable agriculture, clean water access, renewable energy, microfinance and economic development, and affordable access to basic services like housing, healthcare, and education.
Many of these impact issues are derived directly from the United Nations Sustainable Development goals, an interconnected set of 17 goals outlined by the UN to address global challenges related to poverty, inequality, climate change, environmental degradation, peace and justice.
Impact Investments have intentionality, use evidence and data in their design, and are continuously evaluated to ensure that they’re meeting their impact goals. They also have a return expectation or, at minimum, an expectation of a return of invested capital. Impact Investments frequently use illiquid private investment structures similar to Private Equity or Private Debt investments. While many of these fund structures merely target a return of capital they can be implemented by clients who utilize Donor Advised Funds, which provides a tax benefit at the time of donation as well as allowing users of DAFs to “recycle” the capital returned a theoretically infinite number of times within the DAF, amplifying the philanthropic effect of a single dollar amount to many times its original value over a number of years. Common impact investment outcomes achieved with this type of structure are affordable housing development, food and water infrastructure in developing nations, microlending, deforestation abatement, and other project-based goals frequently associated with philanthropy around poverty relief, environmental justice, and international development.
ESG at PPC
As you can see, there are a wide range of ways to define and implement ESG and Socially Responsible Investing, and just like with your retirement or legacy-building goals, our advisors and research team have a wide variety of ways to incorporate your values into your investment portfolio. Whether you’d like to reduce the carbon footprint of your portfolio, promote racial justice or gender equity, support LGBTQ+ issues, workers rights, or a myriad of other issues, our advisors can work with you to tailor an approach that supports the issues you care about in concert with your investment goals.
Don’t know where to start? Pacific Portfolio has many “off the rack” investment solutions, from full model portfolios to customized single-asset-class solutions that address a broad array of Environmental, Social, and Governance issues while meeting our clients’ investment goals.
For clients that want a broad ESG solution that works just like our non-ESG investment portfolios, we have fully ESG-integrated models that provide a stand-alone, fully diversified investment portfolio tailored to your goals and objectives utilizing best-in-class ESG managers, hand-selected by our Investment Committee using the same rigorous process as our traditional Equity and Fixed Income managers.
For clients who would like to start with only a portion of their portfolio or have a particular set of issues they’re passionate about, PPC can also create custom managed accounts that can replace a single asset class and drill down to one or many of over 40 ESG causes, from the prison industrial complex, gender and racial diversity, carbon emissions and toxic chemicals, and many more.
So if you’re ready to put your money where your values are, or just have questions about ESG and Socially Responsible Investing, give us a call at (206)623-6641 or email us at information@pacific-portfolio.com to talk to one of our advisors today!
Views expressed are as of the date indicated; they are based on the information available at the time and are subject to change based on economic, capital market, and other conditions. Any investment decision should be based on an individual’s own goals, time horizon, and tolerance for risk.
Prior performance does not guarantee future results and there is the potential for the loss of your capital investment.
