It doesn’t take a rocket scientist to realize that our environment and the world, in general, are going through a tough time right now. From climate change to corporate greed and everything in between, it is more and more clear that each of us needs to do our part to help our world recover. Recently there has been an increase in those who invest based on their moral principles and values, rather than just on the bottom line. This grassroots shift in demand is propelling sustainable investing forward. I’m Kim, and in this Article, we are going to talk about what sustainable investing is and how it works. Plus, we’ll get into some of the details on the pros and cons of starting your own program of sustainable investing. Amazingly, as recently as the beginning of 2018, over 25% of the US were involved in sustainable investing.
And just to the north in Canada the number is just over 50%, or 2.1 trillion Canadian dollars. One of the biggest asset managers in the world, BlackRock, even pledged to integrate sustainability as a critical part of its investment strategy. This increase in sustainable investing is really encouraging, because of the positive social impact. But it’s also worth noting that this strategy can affect how much you make. First, let’s define sustainable investing. The term “sustainable investing” refers to a variety of strategies used by investors to maximize financial gains while advancing long-term environmental or social value. It can be as simple as avoiding companies or industries whose products conflict with your objectives, morals, and values. You can also invest in ways that you believe will advance certain goals, whether they are environmental, political, or moral. If your passion is protecting marine life, then there is definitely an investment vehicle that will fit your goals. There are two popular types of sustainable investing strategies that are worth diving into. The first is negative screening, and the second is ESG, or Environmental, Social, and Corporate Governance.
Negative screening removes particular industries, businesses, or methods from a portfolio based on what you are trying to avoid investing in. On the other hand, ESG is more like re-weighting your portfolio to emphasize companies with higher ESG scores, which evaluate how much a corporation works towards specific social goals. Both of these strategies are frequently combined in the various index funds that use them. It sounds like a really good idea to have a sustainable portfolio, and it might feel even better than it sounds. But if you want to invest sustainably, then there are two things you need to keep in mind. The first is how much you’ll make. And the second is how much the investment reflects your values and priorities. It is necessary to evaluate these two factors jointly. If a sustainable portfolio has slightly lower expected returns but is a perfect reflection of your views and values, you may be willing to accept the tradeoff. In other words, you are okay with a lower return if the company is living up to your standards.
It’s something you will need to evaluate and come to terms with for yourself. There was a study in 2019 that looked at how ESG scores impacted stock returns. They discovered that businesses with higher ESG ratings typically had lower average returns than those with lower ratings. Basically, the lower the score, the more money was made. They discovered because sustainable investors may be willing to accept lower expected returns simply because they do not want to invest in certain types of companies, it has contributed to higher ESG scores equating to lower returns. The personal preferences, or “taste”, of a successful investor often are not related to their “risk premium”, or tolerance for risk.
If investors have a taste for a particular asset, they may hold it regardless of the expected return. The impact on prices might be significant if there is a sufficient amount of wealth controlled by investors with particular preferences, as is the case with sustainable investors. Another way to look at it is that sustainable investment enthusiasts need to expect higher returns before they will consider financing an unsustainable business. The expected returns of unsustainable businesses increase as a result.
Additionally, in order to invest in sustainable businesses, they are prepared to accept lower expected returns. The expected return of sustainable businesses is lower as a result. In other words, if a company isn’t in line with an investor’s values, it needs to make up for that with higher returns. And this study wasn’t the only one. Others also corroborated the same idea that sustainable investors are willing to take a risk if they believe in what the company does. And, for them to invest in a company that doesn’t share their values, the returns need to be much higher. You’re probably saying, “Kim, this is a lot to absorb.”, and you’re right. So, think of it this way: every investor is different. Each one is going to have different values that influence their sustainable investing decisions.
That diversity of preferences is what helps to stimulate the ESG investing industry. Because if everyone was exactly the same, it wouldn’t really work. Another study showed that, although returns for sustainable portfolios are lower, they lead to a positive social impact. Why? Because this investing behavior encourages sustainable firms to invest more and discourages unsustainable firms from investing due to the effects of investor preferences. So, what does this all mean? Yes, you can promote global change by making investments in businesses that adhere to ESG standards, but you must accept lower expected returns as long as there is a wide range of ESG preferences.
The firms excluded from sustainable portfolios must have higher expected returns in order for sustainable investing to function as it is intended to, which means sustainable investors must have lower expected returns than the preferred free market. By definition, a sustainable portfolio must be less diversified than the market. The increased concentration and decreased reliability of companies with poor environmental, social, and governance, or ESG, scores means we get a less reliable portfolio with a lower expected return. This could be seen as a reasonable trade-off if companies with high ESG scores had higher expected returns, but the results are not the best for investors.
Of course, we also need to take fees into account. A portfolio of globally diversified Canadian-listed iShares ESG ETFs costs about 0.28 percent annually. That’s quite a bit, given that the equivalent iShares ETF portfolio that doesn’t take ESG factors into account, costs just 0.12 percent. The costs typically increase as we strive for greater sustainability. Lower expected returns, less diversification, and higher fees are the costs of a sustainable portfolio In a nutshell, if you practice sustainable investing, you probably won’t make as much money, but you will be in better alignment with your values and beliefs. That’s the sustainable investing trade-off. Even so, I still think going for sustainable investing is a wise decision. But, of course, it really depends on you. In every investment you make, you have to learn all sides of it, and do your due diligence, so your money will not go to waste.