RI (responsible investing), ESG (environmental, social and governance), SRI (socially responsible investing) . . . so many acronyms!
Investors are understandably perplexed by the proliferation of terms and strategies related to environmental, social and governance-focused investment approaches. So why not dispense with all the jargon and, instead, begin by identifying investors’ objectives? By doing so, rather than getting lost in definitions and terms, investors could better determine how to focus their efforts and what actions to take.
Responsible investor objectives can be distilled into the following three categories:
- Principles alignment – Owning only companies that reflect the kinds of activities the investor wants to see in the world.
- Relative performance – Outperforming a commonly referenced, market-cap weighted index
- Improve “real world” outcomes – Influencing companies’ environmental or social impact.
To achieve any of these objectives, investors in public equities have just two options: portfolio construction and active ownership. Portfolio construction refers to how investors select and weight stocks in their portfolio with respect to their environmental, social and governance characteristics. Active ownership refers to voting or engagement activities.
Portfolio construction must be used to achieve the first two objectives. In the case of principles alignment, investors are not trying to change businesses, instead they want to only benefit from business activities they find morally acceptable. For example, investors might require companies they hold to have fair labor practices and to not produce addictive products. For this objective, success is achieved by correctly identifying these companies and precisely matching them against an investor’s concerns.
A relative-performance objective implies an investor feels there is information that isn’t priced into a particular stock, and the investor is looking for a way to take advantage of this opportunity. For example, companies with perceived “stranded” tobacco assets might be avoided or those involved in emerging renewable energy technologies might be emphasized. Although superficially these concerns may sound like principles alignment, the basis for success is very different. In addition to needing to accurately identify companies, relative-performance investors are looking for evidence that their bets generated portfolio outperformance.
Conversely, public equity investors who want to change environmental and social outcomes need a completely different strategy—one that focuses on voting and engagement, also known as active ownership. In these cases, portfolio construction is often intentionally different because investors need to own, rather than avoid, stocks they find unacceptable so that they can work to change the company’s behavior. Practically speaking, most investors don’t actually seek out “unacceptable” companies, they simply let their investment philosophy determine their holdings and, therefore, their voting and engagement activity. Either way, measuring success from active ownership is harder to quantify than for portfolio construction and it requires a higher degree of patience. Typical approaches start by measuring active-ownership activity and then progressing to trying to tie that activity to changes in company behavior or policy. The last step would be to tie that behavior to actual investment performance outcomes.
Of course, investors may want all three objectives within their portfolio, but, to correctly measure success, they need to know where each applies. By clearly identifying their objectives and understanding the practical implications of pursuing each, investors can move closer to implementation and further from the jargon. This is what truly makes the difference, whatever acronym you choose.