November 15, 2020 | Institutional Perspectives | 8 min read

What’s in Your ESG?

Over the last 15 years, responsible investing has grown dramatically in size and scope. Investors’ attention has widened beyond ethical and moral issues to include a range of environmental, social and governance (ESG) factors and signatories to the Principles for Responsible Investing (PRI) have surged to over 3,000, representing over US$100 trillion in assets under management. With the explosion in ESG investing, many new strategies have also emerged to meet the increased demand. In Canada, net inflows into ESG-themed exchange-traded funds (ETFs) have reached $740 million this year alone, and 15 new products have been launched.

With that growth has come complexity. While many funds now carry the “ESG” label on them, many investors are confused about what strategy they are actually invested in. In this article, we will provide clarity on the different responsible investment options out there to ensure that investors understand the differences, and help them assess whether their current portfolio aligns with their investment goals.

ESG is Not Just a Single Concept

Generally, there are three broad approaches under the responsible or ESG investment umbrella: Values-Based or Socially Responsible Investing, ESG Integration, and Impact Investing. Within each bucket there are several different strategies one could follow.

Values-Based or Socially Responsible Investing (SRI) involves aligning a portfolio to a specific set of values or beliefs. Commonly, it involves excluding investments that don’t meet certain criteria. This approach is commonly referred to as negative screening, and has traditionally been favoured by faith-based organizations and foundations not wanting to own companies involved in “sin” industries such as alcohol, gambling, pornography, and tobacco. Over the years, as new issues have emerged, the list of industries in investors’ crosshairs has grown to include fossil fuels, nuclear energy, weapons, and others.

While negative screening might seem relatively straightforward, there are a number of ways it can be done, depending on the specific issue and how it’s being defined. Take fossil fuels for example. Simply looking for a fund labelled “fossil fuel free” might not get you what you think: a quick search of the eVestment database for global equity products that exclude fossil fuel investments yields 125 funds that meet the criteria, 59 of which had some exposure to the Energy sector. This result is likely due to the distinction between screening out companies that own fossil fuel reserves which would exclude oil and gas producers versus those companies that provide services to the industry, such as pipelines.

ESG Integration refers to the assessment of material ESG risks and opportunities alongside traditional financial analysis in the investment process. It is a broader approach that does not prohibit investment in any specific sectors or industries, but an investment manager might come to that conclusion if, for example, it determined the ESG risks at a company were too high and therefore might impact the expected returns. Often, managers using integration
approaches will invest in companies they’ve determined to be leaders in their management of ESG issues, and use active ownership practices to engage with companies to encourage ongoing improvement.

"Take fossil fuel s for example. Simply looking for a fund labelled “fossil fuel free” might not get you what you think: a quick search of the eVestment database for global equity products that exclude fossil fuel investments yields 125 funds that meet the criteria, 59 of which had some exposure to the Energy sector."

Investors in a fund managed using the ESG Integration approach might be surprised to find out that they hold alcohol, tobacco and/or fossil fuel stocks in their portfolio. This is perfectly acceptable under an integration approach, assuming the manager has fully assessed the ESG practices at these companies.

Finally, Impact Investing targets investments for both a financial, and social or environmental benefit. As the name infers, the objective of this approach is to create a positive impact on social or environmental issues such as climate change, education, or poverty. For example, in fixed income markets, “green” bonds are issued to fund projects such as clean transportation (public transit), clean energy, and land management. But there are still varying definitions of what constitutes a “green” project, particularly in the eyes of the investors. A nuclear power project may qualify for funding as it is among the cleanest energy produced when it comes to emissions, however it poses serious environmental risks if an accident should occur. (For more information on green bonds, see our recent article in Canadian Investment Review.)

What’s in a Name?

Compounding the increased complexity for investors is a lack of standards or regulations governing the marketing of these strategies – which has given rise to concerns of “greenwashing,” where asset managers label their funds as “responsible” but aren’t actually walking the walk.

For example, look at the recent downfall of German payments company, Wirecard, a holding of Deutsche Bank’s DWS ESG Investa Fund. After the Financial Times reported accounting irregularities at the company in early 2019, sending shares tumbling, the Fund doubled its holdings in the company through that year. Wirecard ultimately became insolvent in early 2020, eroding years of shareholder value after admitting that €2 billion in assets likely didn’t exist. For a fund that takes into account “best-in-class ESG ratings,” it’s hard to argue that Wirecard was a leader in “G”.

Index funds are not absolved of their duties, either. When Vanguard incorrectly added 11 companies to its $575 million socially responsible ETF, including a gun manufacturer and a private prison, it highlighted the lack of controls in place both at the index provider and at one of the world’s largest investment firms.

And that’s the problem – how does one determine if this work is being done? In the US, the Securities and Exchange Commission (SEC) has taken notice. In March, the SEC announced plans to expand the rules which require a fund’s name to broadly match what it invests in, to also include ESG products. The CFA Institute is also developing a set of voluntary global standards that would establish ESG disclosure requirements for products in order to provide investors with greater transparency on ESG-related features.

While these measures will hopefully result in more accountability for investment managers and increased clarity for investors, it is still up to investors to do their research to ensure they understand what they are invested in.

Determining the Right Strategy

The starting point for any investor wanting to reflect a responsible investing approach in their portfolio is to define their ESG goals and objectives. Key questions to ask include:

• Is there a mission, value, or belief that you want to govern your manager’s investable universe?
• Are your goals broad-based or more customized?
• Do you require absolute exclusions of screened out names or sectors, or are you open to a sliding scale to permit proactive engagement with companies?

Clarifying the answers to these types of questions up front will help you identify which approach best aligns with your goals.

If you adopt an approach that excludes certain investments, having clear policies in place will help avoid confusion. For example, language that states you do not want to own companies with “significant exposure to industry X YZ” is too vague: how do you define “significant” and in what way is the company exposed? Circling back to the earlier example of fossil fuel-free funds, do you want to exclude companies that just own fossil fuel reserves (producers), or does this also extend to companies that provide services to the industry (pipelines)?

When determining significance, you should weigh your SRI goals with the impact of such restrictions on the investment universe and the manager’s ability to achieve attractive returns. These were the types of issues we looked at when we created our Leith Wheeler Carbon Constrained Canadian Equity Fund. We believed that investors who wanted to eliminate fossil fuel investments would also want to eliminate companies that derive the majority of their revenues from the industry, so we established a 30% threshold on revenues to define significant involvement.

If you have broader ESG goals, where you want to know your manager has considered these factors in their evaluation of investments, an ESG Integration approach likely works best. Because of the complexity of the issues involved, the use of passive funds to achieve your goals here warrants some caution. Many ETFs rely on a single, third-party ranking to identify companies for fund inclusion but this approach doesn’t result in the most robust analysis. There are often material differences in the ratings or scores between the various providers due to differences in weightings of the various ESG factors. As well, a company can be assigned a lower score simply because it doesn’t publicly disclose its ESG policies, which unfairly penalizes smaller companies. On the other hand, an active manager who follows this approach will typically use myriad sources to assess a company’s ESG practices, from company reports and discussions with management teams, to a variety of third-party research.

Leith Wheeler’s Integration Approach

While we do consult third-party ratings, it is more for the research than the ratings themselves. Ultimately, we conduct our own independent research, using our decades of experience and relationships with management teams to provide a superior understanding of companies and the material ESG factors that impact them. Assessing the quality of management is a key input into our process, as we find that companies with strong leadership who are good stewards of capital, are also committed to doing right by their employees, their communities, and the environment. Owning large shareholdings on behalf of our clients also enables us to engage meaningfully with management and communicate our expectations regarding their ESG practices. Many of our long-term holdings are companies we admire and trust, such as Toromont Industries, with its strong safety culture, and Saputo, with its commitment to employees, and the safety and quality of their products.

We’ve only just scratched the surface here of an evolving area of the investment world. As investors increasingly turn to their investment portfolios as a means of reflecting their values, the popularity of ESG strategies will only grow. By taking the time to first understand the nuances of the options available, they will be better able to achieve their goals both financially and personally.

IMPORTANT NOTE: This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.

Reg. T.M., M.K. Leith Wheeler Investment Counsel Ltd.
M.D., M.K. Leith Wheeler Investment Counsel Ltd.
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