Sustainable investing: the cost and impact of doing good

In December, I wrote a blog post called “A client primer on sustainable investing,” which was a broad introduction to sustainable investing. In this post, I’m focusing on two topics that frequently come up when advisors discuss sustainable investing with their clients: 1) the perceived opportunity costs, and 2) the impact of investing through a sustainable lens. 

Putting your money where your conscience is: What’s the cost? 

Clients frequently ask if they are sacrificing investment performance by incorporating sustainability themes into a portfolio. After all, the process of either screening out undesirable companies or favoring those that score higher on certain environmental, social, or governance (ESG) metrics is, by definition, limiting the available investment universe.  

It seems reasonable to assume that placing limitations on particular companies that could be over or underweighted—or even owned at all—would have an adverse impact on an investor’s ability to successfully select the most attractive securities. There are even some contrarian strategies whose investment approach is predicated on explicitly seeking out and buying stocks of companies that other investors might exclude, e.g., “sin stocks” (alcohol, tobacco, adult entertainment, etc.).

However, a large body of evidence contradicts this expectation of a performance shortfall. There are thousands of empirical studies that demonstrate that the use of sustainability criteria in the portfolio construction process does not disadvantage performance (here’s just one example). In fact, some show better long-term performance by companies scoring higher on different ESG criteria, and others show a degree of downside protection during crisis periods. All in all, it’s difficult to make an evidence-based case against sustainable investing based on performance alone.

Of course, it’s wise to expect to see at least some time periods in which sustainable investment strategies could be at a disadvantage. For example, companies within the energy and utilities sectors would generally score lower on environmental criteria than technology and consumer sectors. That might lead a hypothetical investor to underweight the lower-scoring sectors and overweight the higher-scoring ones. In that scenario, if the energy and utilities stocks outperformed, it would represent a headwind for such a mandate. That said, those performance cycles tend to be cyclical and temporary.

Can we change the world? The impact of ESG investing

The second common topic that could arise in client conversations is the true impact of investing using ESG criteria. An objection might sound something like, “My portfolio is too small to matter. Corporations won’t notice if I’m excluding their stocks. Why not just invest to maximize returns and then donate some funds to a local charitable organization?” 

While I understand the logic of this objection, I think it misses the point as to why people engage in sustainable investing in the first place.

There’s a concept in psychology known as cognitive dissonance. One aspect of the theory is that people experience discomfort when they act in a manner inconsistent with their beliefs. Certainly, there are plenty of examples we can find; for instance, I’m opposed to animal cruelty but I still eat meat. Giving up my carnivore tendencies entirely would be difficult for me, so I may just choose to live in denial about this inherent inconsistency. Or I might try to reduce my internal discomfort by making a concerted effort to seek out more humanely raised meat products.

When it comes to investing, though, structuring your portfolio to align with your beliefs can be accomplished relatively easily. Investing can represent more of an expression of personal values than a means to an end. One could make money owning a company that sells nicotine products or exploits child labor, but doing so would produce cognitive dissonance. 

For many investors, avoiding that inner discomfort may be more important to them than the marginal profit that a portfolio could generate. And while monetary gains are great, many investors prefer not to profit from business practices they view as harmful or unethical. Consider this: if you can easily invest in an ethical manner and not give up any potential performance advantage, why wouldn’t you do that?

ESG and goals-based investing

SEI has long been a proponent of goals-based investing. In addition to growth, stability, income, and tax management, investing in a sustainable manner may be evolving into an important client goal in its own right. Taking this into consideration at the outset can allow you to have more meaningful discussions with your clients. Instead of pushing back against their interest in sustainable investing (as I myself might have done in the past), it will likely be more productive to explore their motivations in more depth. It may be more important to them than you realize, and you may be able to support this goal more fully than in the past.

Environmental, social and governance (ESG) guidelines may cause a manager to make or avoid certain investment decisions when it may be disadvantageous to do so. This means that these investments may underperform other similar investments that do not consider ESG guidelines when making investment decisions. 

ESG and Sustainability are not uniformly defined across the industry.

Please note: A third-party investment screen vendor can vary from any other screening vendor and/or a financial advisor with respect to its methodology for constructing screens, including the factors and data that are collected and applied as part of the process. As a result, screens may differ from or contradict the conclusions reached by other ESG vendors and/or financial advisors with respect to the same issuers. A selection of a screen will likely contribute to performance deviations from an original strategy. 

It is important to consider limitations of research studies, especially in regards to ESG studies and carefully consider that such studies are not indicative of the future performance of any particular ESG strategy. 
Investing involves risk including possible loss of principal. There can be no guarantee that risk can be managed successfully.

Glossary:
Alpha (α): the excess return relative to the return of the benchmark.
Return on assets (ROA) – a metric that indicates a company's profitability in relation to its total assets.
Return on equity (ROE) – a measure of financial performance calculated by dividing net income by shareholders’ equity.
Sharpe Ratio – describes how much excess return you would expect to receive for the extra volatility you endure for holding a riskier asset.