This is a thought leadership article by North American member firm Lutz discussing how to implement ESG.
Most investors are familiar with the terms ESG, socially responsible, and sustainable investing. However, these investment philosophies can mean very different things to different investors. Over the past ten years, investors have flocked toward responsible investing. ESG has blazed a new path into the mainstream investment community. Whether it’s institutional investors or individual investors, assets have steadily moved into ESG funds.
In fact, nearly one in four dollars under professional management in the U.S. are currently in ESG oriented investments. 2020 marks the year that ESG related funds have reached $1 trillion in assets. The recent surge of investors to the ESG landscape has attracted many players to specialize in this field. This has led to an abundance of data that requires particular expertise to filter through and apply to focused strategies.
ESG stands for Environmental, Social, and Governance. People have come to realize that these factors aren’t just about improving the world, but they can also help manage risk within portfolios. It is safe to assume that the Environmental and Social aspects are more commonly known throughout the industry. DFA tailors to investors whose values align specifically with sustainable or social investing by offering exclusive options for both. I will touch more on these later.
However, ESG is also broadly implemented throughout all of their equity and fixed income strategies. Many wonder if ESG is a standalone factor that leads to higher expected returns, similar to commonly known factors like small capitalization and value companies. Extensive research has not found a reliable relationship between higher expected returns and ESG factors, like emissions intensity, for example.
Our belief is that material information, financial or non-financial, is priced into the market by investors. ESG does encompass material aspects about companies, and therefore allows the market to incorporate this information into prices quickly. Even though ESG factors may be priced into the market, there are still ways to use it to add value to portfolios.
Broadly Integrating ESG
DFA broadly implements ESG in all their portfolios through risk management. This is where the governance aspect of ESG comes into play. Risk can be managed by looking at elements of governance to prevent investors from situations where owning a particular stock may not be beneficial. One example of this is excluding companies that are closely held. These are companies that have a large percentage of their outstanding stock owned by insiders. This can put investors in a situation where insiders can take advantage of minority shareholders.
Another example is monitoring companies that are listed on exchanges. To be listed on an exchange, companies have to meet specific requirements. Companies must be listed on approved exchanges to be considered for ownership.
The third example is running daily news checks. These news checks look for companies that are involved in controversies, whether it involves ESG or not. This may be a reason to put a halt on buying any more of a company’s stock.
Governance has a direct impact on a company’s valuation and expected return. Companies with a track record of poor governance & oversight practices tend to be considered riskier by investors. To combat this, DFA looks to engage with companies to help manage risks with the goal of improving future returns. They have largely expanded their stewardship and proxy voting methods to reach as many companies as possible in an efficient manner.
Sustainable and Social Investing
At Lutz Financial, we recognize some clients have specific ESG goals, and we offer solutions that can accommodate them. From an environmental standpoint, we can construct portfolios using DFA sustainability funds that pursue lower exposure to companies with high greenhouse gas emissions or potential emissions from fossil fuel reserves, companies involved in toxic spills or factory farming, in addition to other factors important to investors. On the other hand, the DFA social funds seek to exclude individual companies involved in controversial activities, like abortion, gambling, adult entertainment, etc.
We believe that the choice to adopt a value-driven approach should not have to come at the expense of sound investment principles. The common misconception is that you must give up some return to pursue responsible investing. By integrating sustainability and social considerations with an investment solution that focuses on broad diversification and tilting towards sources of higher returns, that does not necessarily have to be the case.
Many investors around the world are increasingly aware of the effect that harmful business practices can have on the world. As a result, the ESG investment landscape has become dynamic and will continue to innovate. It is important to understand all of the ways it can be implemented in an investment strategy.
Investors are prone to flocking to “the next big thing” regarding investment trends. However, ESG isn’t just a popular trend that is currently hot. Its sheer size and asset growth rates tell us that it is a sustainable trend.
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Since our founding in 1980, Lutz has steadily grown because of our integrity, work ethic and collaboration to become the largest locally owned firm of its kind in Nebraska. Our clients' goals are our goals and we believe that understanding our clients is a vital part of getting to the bottom line and ensuring their success. We provide accounting services such as tax, assurance, business consulting and valuation. We also support our clients in the areas of investments and planning, recruiting and technology services.Learn more