Sustainable investing, in all its forms, is making its way into investing mainstream. The clearest illustration of this trend is the chart below from the US SIF Foundation, showing growth in so called “ESG” managed assets. Environmental, Social and Governance (ESG) analysis is primarily a quantitative approach to managing those risks within a portfolio surrounding these key areas. Unfortunately, ESG has become somewhat of a catchall term, covering any strategy that in any way involves some type of environmental, social or governance management. This makes it difficult for investors to differentiate between strategies– or to separate signal from noise.

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The sustainable investing landscape as it stands today can be categorized into three distinct buckets:

1. Shareholder activism– the use of shareholder resolutions and proxy voting to push for change at publicly traded companies.
2. Public market ESG & SRI (Socially Responsible Investing) strategies– the use of exclusionary or peer-relative ranking approaches to align portfolios with values and manage environmental, social and governance risk.
3. Impact investing– direct private investments that seek to address specific social or environmental challenges.

The three sustainable investing categories above are presented in the order of their evolution in the industry. The activist shareholders who have pushed for change and transparency at corporations have been hard at work for decades. Activist efforts have paved the way– through a significant improvement in available data– for more robust public market screening (SRI) and risk management (ESG) approaches. The success of public market strategies and growing investor interest in addressing environmental and social challenges head on has led to an explosion of private market investment options. Each of these categories presents investors with unique opportunities as well as complexities and challenges.

Focusing on the public equity (stock) market, there are three broad types of sustainable investing approaches (beyond shareholder activism):

1. Value-based exclusions– A traditional SRI approach that prohibits a portfolio’s exposure to those businesses that come into direct conflict with the investor’s unique value set.
2. ESG peer ranking– An approach that sees institutional investors using quantitative scores, based on peer rankings within industries, to determine how companies are positioned to manage potential environmental, social and governance risks.
3. Thematic investing– Strategies that emphasize certain types of businesses within a portfolio, such as alternative energy or companies targeting a diverse workforce.

With interest in sustainable investing growing quickly, mutual fund and ETF (exchange traded fund) providers are falling over each other in a race to bring products to market. Unfortunately, in the rush to sell products, many funds with the “ESG” label in their names or marketing materials do not fully address investor needs. Some can even lead to investors taking undue risk.

As an example, some individual investors with environmental concerns may choose to exclude or minimize fossil fuels and include alternative forms of energy. This approach sounds admirable and logical, given rising levels of CO2 in the atmosphere. Unfortunately, a rapidly shifting regulatory environment and other factors have led to severe under-performance of alternative energy investments, with a broad measure of these stocks down about 8% annually over the last ten years. Adding thematic exposure to a portfolio without considering investment merits can lead to significant performance deviations (relative to the broad stock market).

Separately, an investment in a true ESG strategy should help reduce environmental, social and governance risk within a portfolio. A growing body of academic research indicates that ESG strategies which exclude or de-emphasize lower scoring companies can improve risk adjusted returns over time (relative to a broad market benchmark)*. The problem for many investors is that most true ESG strategies include the best companies across all industries, even the potentially undesirable ones: the best coal company, the best weapons manufacturer, the best tobacco company, etc. Some investors find this exposure unpalatable.

The good news is that, with the right approach, investors can do well while also doing good. As with any investment strategy, investors should know what they own and ensure that their risk exposure is consistent with their risk tolerance and long-term financial objectives. Perhaps the best approach is to work with an advisor to find the right balance of sustainability and personal financial objectives.

At F.L.Putnam, we combine a thoughtful approach to ESG analysis with the ability to screen out objectionable businesses and, when appropriate from an investment standpoint, the inclusion of desired thematic exposures. Contact us if you’d like to learn more.

*-Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2464204