What Is ESG Integration & Why Does It Fall Short for Many Ethical Investors?

What Is ESG Integration

How can people ethically invest in companies? It’s an important question, but it’s often met with an unsatisfactory answer. Some proponents of ESG integration say that if enough investors demand better governance from the companies they invest in, those demands will be answered. Unfortunately, that isn’t how the marketplace works; companies are beholden to their shareholders and not to other stakeholders such as employees, customers, or citizens affected by business activities.

What is ESG?

As an investor, you can choose to invest according to your principles. Many fund managers have adopted some environmental, social, or governance (ESG) investing philosophy—after all, as your values change and evolve, so should your investments. There are three common philosophies within green investing: exclusionary (which bans firms from an investment that violates certain standards), additive (whereby companies are selected based on how they perform against certain metrics), and integrated or blended (which incorporates both). Of these three philosophies, blended tends to be the most widely used because there is no real way of predicting which metrics will prove most valuable in future market scenarios.

Why Responsible Investing Is Good for Investors

ESG integration: One of ESG’s biggest flaws is its integration into mainstream investment. It’s hard to make a case that environmental, social, and governance considerations are being integrated when they are still considered an alternative investment strategy. The reality is that a new way of thinking is needed about investing, which considers values and financial goals. That means going beyond just choosing companies based on their environmental or social impact—there’s a need to evaluate companies based on their impact on humankind writ large.

ESG integration explained.

The term ESG integration refers to an investment strategy that takes into account a company’s environmental, social, and governance characteristics when making decisions. Ethical investment is a subset of socially responsible investing and encourages investors to consider companies’ impacts on society beyond financial performance. In some cases, corporate decisions and policies overlap, leading to positive or negative repercussions for various stakeholders.

ESG integration

It’s important to note that while ESG integration—consisting of social, environmental, and governance factors into traditional financial analysis—has its roots in positive impact investing, that doesn’t mean an investor has to limit their investment choices to only those companies with a positive impact. The two are complementary approaches.

Impact investors look to where they can make investments with a positive social and environmental effect. They may choose not to invest in certain companies due to their negative impact on society or make larger investments in these types of companies as an additional way of supporting what they believe will help humankind flourish.

Proposed Changes

ESG-integrated portfolios have some restrictions that don’t apply to traditional portfolios. For instance, you can’t purchase funds based on algorithms that use correlation trading strategies or use funds with high turnover rates. Hedge fund managers often use these tools to enhance returns or reduce volatility, and they’re strictly prohibited in an ESG-integrated portfolio.

In addition, you must put your portfolio under regular review and potentially rebalance it when necessary to ensure your goals are still being met. For example, suppose a sector formerly thought of as green starts polluting significantly more than previously believed. In that case, you might need to sell shares in companies within that industry before changing course on an investment strategy.

What is Sustainable, Responsible, Impact (SRI) Investing

Sustainable, Responsible, Impact (SRI) investing represents any investment strategy explicitly considering environmental, social, and corporate governance (ESG) factors in portfolio construction. While broader-reaching than merely socially responsible investing, SRI is often closely associated with these types of investments. Green America’s 2016 investment report on their members’ portfolios shows that over $61 billion of assets are invested in sustainable and responsible funds.

Why Responsible Investing Is Good for Investors

A growing number of asset owners—nearly 10% at last count, according to a recent report —are making their portfolios more environmentally friendly and socially conscious. One way they do that is by integrating environmental, social, and governance (ESG) factors into their investment decisions. This can help give all sorts of investors a more accurate picture of potential risk and reward—and produce better returns as well.

How so? Including ESG data in investors’ decision-making processes can make them aware of risks that might otherwise be overlooked. In other words, when you look at an industry holistically instead of just judging its finances on paper, you may find some ugly truths: low wages paid to workers, harmful working conditions, and weak oversight on both fronts. These are just three examples out of hundreds—but even small changes could have big implications down the line.

Why most Sustainable, Responsible, Impact (SRI) investing falls short

From an investor’s perspective, it isn’t very easy. SRI portfolios hold stocks and bonds of companies considered good corporate citizens. By definition, SRI funds invest in stocks and bonds (or loans) issued by corporations with a history of good management practices and responsible treatment of their workforce, customers, and community. They also are held to higher standards on environmental issues. As far as most financial advisers can tell, these investments earn similar returns as regular investment funds—though they typically charge higher fees. Unfortunately, despite these good intentions, over time, sustainable investing hasn’t proven to generate either better or worse returns than mainstream investments–despite its higher fees.

How new sustainability metrics can help SRI investments succeed

The idea of integrating corporate sustainability into investment strategy isn’t new, but what used to be an emerging field has become mainstream. According to The Forum for Sustainable and Responsible Investment, or FSRI, asset owners managing $25 trillion in assets are engaged in sustainable or responsible investing. While that sounds like a lot of money, it’s not; it represents less than 5 percent of global assets under management. More fund managers need to adopt and stick with sustainable investing methods to impact how companies operate and how to invest money in the future.

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To Summarize

Investors also measure their companies against criteria that aren’t necessarily rooted in financial measures but rather concern how they treat people, whether they provide good value to society and whether they are good corporate citizens. These are known as environmental, social, and governance issues. But measuring these issues against standards set by non-profits can fall short if an investor truly wants to make an impact on humankind. The solution: Take time to engage with companies to create a deeper understanding of their goals and progress, help develop new metrics and push them beyond outdated practices.