Exploring the Sustainable Investor’s Toolkit

12.10.2020 - Jeff Finkelman, Vice President, Sustainable Investing

Sustainable investing has grown in popularity, but it still may trigger eye rolls in some financial circles. In a recent Wall Street Journal op-ed, Burton Malkiel, the author of A Random Walk Down Wall Street, warned investors against allowing environmental, social, and governance (ESG) concerns to influence their investment decisions. “Putting all your investment portfolio into ESG funds,” he wrote, “is neither prudent nor virtuous.” Like other critics before him, Malkiel seems to rest his argument on the assumption that sustainable investors all expect to beat the market while saving the world. If a sustainable strategy fails to deliver on either count, it is enough to dismiss the discipline in its entirety. In our opinion, sustainable investing simply cannot be painted with such a broad brush.

The reality is that sustainable investing is not a uniform practice aimed at achieving a single goal. We think of it, instead, as a toolkit that investors can use to pursue a wide range of goals. Some tools in the toolkit are designed to generate financial outperformance and others are not. Some tools focus on values and mission alignment, while others are used to generate impact. No one tool is better than another. What matters is that investors select the combination of tools best suited to achieve their own unique set of objectives.

The Sustainable Investing Landscape

Impact Management Project; GIIN
First Tool of Alignment: Values-Driven Investing Screens Out “Offenders"
The first set of tools in the toolkit are primarily used to ensure a portfolio remains aligned with the ESG goals of an investor. The most well-known is values-driven investing, or the practice of avoiding investments that conflict with one’s values, beliefs or worldview. Sometimes called socially responsible investing (SRI) or negative screening, the origins of values-driven investing dates back to the late 1700s. Modern iterations of the approach are evident in fossil fuel-free investments and strategies that avoid gun makers, alcohol producers, coal companies and other “offensive” industries.

Values-driven investing is an important tool for investors that feel uncomfortable profiting from the success of companies they would rather avoid. However, eliminating these firms from a portfolio may come at a cost. Investment theory suggests that using non-financial criteria to restrict the investment universe could result in lower risk-adjusted returns. Most values-driven strategies use portfolio optimization techniques to minimize the potential harm. Once offending companies have been removed from a portfolio, managers typically re-weight the remaining holdings to replicate, as closely as possible, the characteristics of the original portfolio. Nonetheless, investors should consider how much of a deviation in performance they can tolerate before applying a negative screen.

Second Tool of Alignment: ESG Investing May Help Drive Performance
The second tool of alignment is ESG investing, a group of strategies that use ESG data and analysis to inform the investment decision-making process. We recognize three main styles of ESG investing: integration, tilting, and thematic. Integration strategies are typical of active fund managers that use fundamental company analysis to select securities. These managers look at the ESG performance of a firm alongside its financial metrics when making their buy and sell decisions. By contrast, tilting strategies are often passively managed and use ESG-based rules to weight the holdings in a portfolio. For instance, they might lean towards companies with strong ESG performance and away from those with weak ESG performance. Finally, thematic ESG strategies are organized around specific social or environmental themes such as clean energy or gender diversity.

In the last decade, ESG investing surpassed values-driven investing to become the most commonly used tool in the sustainable investor’s toolkit. One reason for the shift is that a growing number of investors, including those without an explicit commitment to sustainability, regard ESG analysis as a potential driver of investment performance. Many ESG investment strategies root their analysis in the concept of “materiality,” or the idea that ESG factors should be rigorously evaluated, but only when they are relevant to the financial performance of the investment. How well a bank manages its water consumption may matter from an ethical perspective, but the quality of its data privacy policies is likely far more relevant to its stock price.

Tools for Impact: Making a Difference with Impact Investing
Values-driven and ESG investing both send a signal to the market that social and environmental issues matter, but investors rarely expect those tools to deliver specific non-financial outcomes. Impact investments, by contrast, are made with the explicit intention to “generate positive, measurable social and environmental impact alongside a financial return.”

The Impact Management Project, an industry initiative, describes three primary tools impact investors use to affect change. The first is engagement. When purchasing a security, investors not only gain an economic stake in a company, but also influence. Some impact investing strategies use that influence to exert pressure on companies to improve their ESG performance. A second tool is growth capital. Investors can make investments in “new or underserved markets” where private capital has the potential to drive social or environmental change. The United Nations estimates that $2.4 trillion of investment will be needed through 2035 in order to limit global warming to 1.5 degrees. Impact investments in renewable energy, energy efficiency and the circular economy will all be needed to achieve that goal.

Neither of these first two impact tools requires investors to sacrifice return or accept uncompensated risk. They comprise the subset of sustainable investing strategies that sometimes do seek to “save the world” and “beat the market” at the same time.

The last impact tool, providing “flexible capital,” differs in that it involves intentionally sacrificing investment performance as a means of generating social or environmental change. This might involve lending to a social enterprise at below-market rates or forgoing liquidity to give a mission-driven company time to mature. Flexible capital is most effective when used to fill a gap between the limits of philanthropic support and return-maximizing capital.

A Final Thought
Critics may portray sustainable investors as naïve “do-gooders” with misguided ambitions. But the variety of sustainable investing tools today, each suited to a different purpose, highlights the industry’s sophistication. We believe interest in sustainable investing has only just begun to grow. Sustainable investing tools dismissed as niche today may become permanent features of the investment landscape tomorrow. 

1. Source: Wall Street Journal, “Sustainable Investing Is a Self-Defeating Strategy” Burton Malkiel, 9/18/2020. 2.
4. Ibid.
5. Source: Intergovernmental Panel on Climate Change, “Global Warming of 1.5⁰ C”; 2018. 6. A circular economy is an economic system aimed at eliminating waste and the continual use of resources.

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


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