Sustainable investing terminology can be perplexing. Rather than clearly define their terms, asset managers assume a high level of prior knowledge and frequently lapse into jargon.

As I outlined in my first post, this lack of clarity creates confusion. Referring to your capital allocation strategy as ESG investing particularly grinds my gears. How does using a TLA aid transparency? Not everyone knows ESG refers to environmental, social and governance characteristics.

Even if you do know what the component parts of ESG are, it doesn’t help you to understand what the manager is trying to achieve. And that’s because ESG is not a philosophy – it is just one of the tools used by sustainable investors.

Stock selection

To understand how ESG factors are helpful to the investment process, let’s take a closer look at how an active manager decides which companies will be included in their investment portfolio.

An investment analyst – who works with the portfolio manager running the fund – will take a close look at the financial metrics of a particularly company. They will consider that firm’s profitability, its ability to generate cash flow and its debt burden.

Analysts will also look at whether this company is likely to grow well in the future, to improve its ability to generate cash and to expand market share. Finally they will look at the share price of the company and decide whether they think the company’s future is reflected in its current value.

New source of information

Until recently financial metrics, future prospects and current valuation were the three main criteria used by active asset managers to select a stock. But the evolution of sustainable investing meant other factors started to be considered – the component parts of ESG.

Now asset managers consider the environmental impact of a company, its supplier and its customers. They want to know more about its social practices. For example, does it treat its labour force well? Has it ensured its suppliers do not, for example, use child labour? The company should also have a strong diversity and inclusion policy and be well governed.

Many asset managers started to include ESG factors in their investment process because these characteristics helped managers to avoid risk. A company might, for example, have good financial metrics, a strong future outlook and be fairly priced and seem to be a screaming buy.

But a closer examination of ESG metrics might reveal, for example, that the company has a lousy environmental record with no plans to improve it; shoddy labour practices or a male-dominated executive board with a predilection for taking bribes.

Taking ESG factors into account could help a portfolio manager avoid a company which, at first glance, looks like a bargain but should be avoided at all costs.

How investors use ESG today

Today ESG factors are not just used by active managers building a portfolio of a small number of stocks, they are also used by providers of passive products.

While an active manager cherry picks the stocks to be included a portfolio, passive providers instead sell a basket of stocks which represents an index, like, for example, MSCI World. This benchmark includes 1,561 stocks from 23 markets.

In other words, a passive provider doesn’t select stocks, they allow investors to allocate – in a neutral manner – to a particular asset class, such as, global equities.

Implications for scheme members

If you are employed and have an auto-enrolled pension invested in the default fund, there is a strong likelihood you have a passive allocation to equities included in your pension pot. This probably tracks a global equity index.

Pension schemes now recognise the importance of ensuring their scheme members are not overly exposed to the risks associated with bad ESG characteristics. To reduce these dangers, they have switched away from traditional indices towards ones which favour companies with strong sustainability characteristics.

While this will protect members from certain risks, it can create other hazards. And it is questionable whether this type of asset allocation will do enough to build a more sustainable future. These issues will be examined in a future post.

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