Find out how investors can build a socially responsible portfolio that can bolster their beliefs and their bottom lines.
How should investors build responsible portfolios?
Investors should know whether their primary motivation is ethical consistency or the pursuit of alpha. This isn’t to say that the two are incompatible, but the manner in which they’re achieved and evaluated is different. In the case of ethical consistency, success means owning companies aligned with investor priorities. For example, if one investor’s focus areas include labor standards, owning a company that produces innovative environmental products but doesn’t pay fairly or provide safe working conditions would be unacceptable. Furthermore, owning the least worst company might not be palatable either.
Meanwhile, an alpha-seeking investor would evaluate a company solely on the basis of its financial prospects. For example, if a company’s pay practices or working conditions were poor, but those conditions weren’t expected to have a negative impact on the company’s revenue or costs, the investor may still choose to own the company. Or if a company produced innovative environmental products, but its market growth opportunity seemed to fully priced in, the investor might not own that company.
Once investors have determined how they want to think about responsible investing, they can begin building their portfolios using the following process:
Step 1: List issues of concern
Investors should begin with a list of all their environmental and social concerns. Things we’re hearing a lot about from investors include things such as greenhouse gas emissions, gender parity, plastics in the ocean, gun violence, and human trafficking. This list can be as long or as short as the investor wishes. The concerns can be very precise or more general. Getting them down on paper is a necessary part of the process.
Step 2: Determine which items pertain to the portfolio
Investors should next identify the issues on their list that are in scope for publicly traded corporations. Not all will make the cut. In the case of a publicly traded company, the concern should relate to the kinds of products it sells or the way it conducts its business. Some concerns may qualify on that front but may be better addressed through public policy, such as regulating or containing plastic pollution. Other concerns, such as innovations in renewable energy, may be better suited for private companies or start-ups.
Step 3: Identify active ownership opportunities
The next step is to circle the items where investors believe company behavior can be influenced—as long as they have the patience to try to see that change through. These concerns will form the basis of the active ownership practices they can use to push for corporate change—for example, voting in favor of shareholder resolutions calling for greater representation of women on a company’s board or reductions in greenhouse gas emissions. Investors need a portfolio that allows them to own the kinds of companies they seek to influence—a broad diversified exposure can be helpful—and ensure their asset manager’s voting and engagement activities support their desire for change.
Step 4: Create a portfolio construction plan
Hopefully this leaves a much shorter list of items that investors can either map to a prebuilt portfolio or use to build a customized one. Any remaining issues should be relevant to public companies but not have realistic potential for corporate change. Using this list in portfolio construction, investors can steer clear of companies that, say, sell tobacco while embracing companies that are, say, sharia-compliant. However, they’ll need to be willing to accept any potential or tax efficiency trade-offs that may arise from owning a somewhat different set of securities due to ESG criteria.
The bottom line
Being disciplined about figuring out what investors want to achieve and how to get there is critical to determining the best approach for building a portfolio. It’s best to use ESG screens only when necessary and to use active ownership to influence company behavior. While it may take some work, the result will be a portfolio with the potential to bolster investors’ beliefs and their bottom lines.