What is sustainable investing, and should I consider it as part of my portfolio?

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Recently, I was asked by a client, who is a business ethics professor, to teach a session to her undergraduate business students. It was a surprisingly fun conversation and many students had very good questions. One topic the class asked about was sustainable investing.

Broadly, sustainable investing can be defined as an investment strategy that includes environmental, social and/or corporate governance factors in the investment process.

A few factors one might typically consider when deciding what to invest in are risk, rate of return and cost. Sustainable investing brings in another factor: Will a particular investment make the world a better place?

Globally, more than $30 trillion is invested with a sustainable lens. Recent research has found different investors embrace sustainable investing for different reasons. Your personal priorities govern the type of sustainable investing that will best align with your goals, such as those listed below.

Financial priorities – Some investors may not be as interested in investing “morally” but may do so anyway if they expect to earn higher returns from stronger-performing companies.

Impact priorities – Other investors may not care whether sustainable investing brings higher expected returns as long as they can shun “bad” companies and/or invest in “good” ones.

Blended priorities
– Many investors fall somewhere in between. They want to earn solid returns (or at least not lose money) while investing in principled ways.

Sustainable investing can include a range of investment solutions that incorporate these and other strategies to varying degrees.

ESG investing is one of the broadest ways to put sustainable investing into practice. ESG stands for Environmental, Social and Governance. In other words, how responsible is a company with its environmental practices? Does it contribute positively to the community? Does it have ethical management practices? Many mutual funds and exchange-traded funds exist that only include companies that rate above average in these areas. ESG fund managers may also engage in active ownership on behalf of their shareholders. Many investment professionals believe it is possible to design a portfolio using ESG funds with similar risk and return expectations as a normal diversified portfolio. ESG factors are used in conjunction with traditional valuations, and the primary goal remains financial performance.

Impact investing seeks to fund a cause with less regard for how the “investment” works out.  Hint: If you are mostly in it for the money, impact investing should not be your focus. Impact investors are on a mission to not just invest in a venture but to become an altruistic partner in it. For example, you donate to a GoFundMe campaign seeking to create an eco-friendly alternative to plastic water bottles. You have just become an impact investor. On a grander scale, high net-worth investors may take on private equity or debt structures with an eye toward making an impact with their funding. The goal of impact investing is the success of the project, not primarily financial returns.

Socially responsible investing (SRI) falls somewhere in between. You do not want to lose your shirt, but you may not mind giving up some expected return if you expect it to do a lot of good. SRI funds are more likely to use screening strategies that involve making security- or sector-specific judgments or forecasts. You might reasonably expect to earn a good return, but you do not know if you should expect less or more than other investment options, and you want to generate these returns without violating your personal ethical standards. An example of SRI might be investing in renewable energy, which might provide satisfactory returns while helping the environment.

Does owning sustainable investments cause companies to change?

Logically, greater demand for corporate attention to sustainability should bring greater attention to sustainable issues. As in an election, collectively, each of our votes makes an impact that we may not be able to affect individually. On the other hand, because markets are efficient, whether you or I invest in a company may not impact that company’s stock price. Someone else in the world will probably step in and buy a company’s shares if we do not. In other words, a company’s management, or other shareholders, may not feel any negative impact if, individually, you or I decide not to buy shares of that specific company.

It is notable that major fund companies who own thousands of company shares are assessing sustainability risks to determine how they vote their shares, whether a specific fund has a sustainability policy or not. For example, last year BlackRock, one of the largest asset managers in the world, said climate change would have a material impact on how they vote shares in all companies their funds own because they view it as a significant long-term business risk. This broader attention could have more impact on company management decisions than individuals deciding whether to invest with a sustainable lens. BlackRock, Vanguard and State Street collectively own 20% of all publicly traded shares of the S&P 500. They represent a huge voting block to which individual companies pay attention.

Does sustainable investing lead to better (or worse) investment returns?

On any given day, you can find an article to support your opinion about whether sustainable investments deliver better returns or not. Mostly these articles are not a reliable source of information. The verdict is still out on whether an ESG focus leads to better (or worse) long-term investment results.

It would be quite powerful if an ESG focus could be shown to provide better investment results. Could we determine ESG is a factor that we could utilize, like other factors (value, size, profitability) to earn better investment returns? If so, companies would have even more incentive to improve their approach to environmental, social and governance issues. Unfortunately, that evidence does not yet exist. Fortunately, though, there also is no conclusive evidence that prioritizing ESG necessarily reduces investment returns either.

Should I utilize sustainable investments?

In the end, sustainable investing really depends on how important it feels to you. Sustainable investing may have some impact on the world around you, and it is important to realize there are also other ways, beyond investments, where you might have even more impact. If an issue is a high priority for you, then donating to an advocacy group or volunteering your time on that issue may have even more impact and be personally rewarding, as well.

As my ethics professor client says, “Every little pebble creates a ripple.” From an ethical perspective, consider how you want to align your actions and values. Whether through investing or other actions, you get to decide how you want to contribute to making the world a better place for yourself and others.

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