When an investment trend emerges you can count on the asset management sector to develop terminology which is loosely defined, populated with three-letter acronyms and usually creates more confusion than clarity.
Sustainable investing is no exception. Managers will talk about sustainable or responsible investing without clearly defining their terms. Some use the phrase socially responsible investing while others view this as out of date terminology. The three-letter acronym ESG is sometimes used to describe sustainable investing, other times to describe a specific analytical process.
Some want their investments to address the UN’s sustainability development goals and a growing number talk about impact investing, which may or may relate to those sustainable development goals, often referred to as SDGs – another TLA!
With so many different definitions available, I’ve chosen to use sustainable investment as my umbrella term as I feel it best captures the quintessence of this investment style – the goal of using capital to improve society. For others, however, it is just one particular investment philosophy.
This series of posts aim to provide some clarity to the rapidly growing trend of sustainable investing. It will start with the basics, explaining the different styles of portfolio design and the tools available to asset managers before moving onto more in-depth discussions.
Philanthropy or return?
Sustainable investing aims to combine two previously mutually exclusive goals – generating returns on investment and philanthropy. These two unrelated targets have been transformed into a spectrum of capital, as neatly illustrated here by Karen Shackleton.
At one end of the continuum is traditional investing focused solely on the delivery of returns irrespective of the impact on society. At the other is philanthropy, which pays no heed to investment norms but is only focused on improving society.
In between these two extremes, a range of different sustainable investing options have evolved. The lightest touch is responsible investing which is focused on delivering return but is principally focused on mitigating risks such as the impact of climate change.
Closer to the philanthropic end of the scale is impact-drive investment which can tolerate below market returns as long as investments have a positive contribution to people and the planet.
The tools available to fund managers
This range of options means investors are able to select the type of investment options which best suits their own values and goals. Investors use a number of different tools to achieve these targets, which are used to a greater or lesser degree throughout the sustainable capital spectrum.
- Exclusion
Whether you are a responsible investor who wants to avoid risks or an impact-driven investor looking to improve society, exclusions can be useful as a way of avoiding certain harmful industries such as coal production, tobacco stocks or weapons manufacturers.
- Selection
A responsible investor is principally focused on using sustainable investment principles to mitigate risk. Once harmful industries have been excluded, the next step is to ensure other hazards have been minimised in the portfolio. This is done by evaluating the environmental, social and governance (the ESG TLA mentioned further up) characteristics of different companies. Investors can then ensure their portfolio is tilted towards those companies with strong ESG characteristics.
- Engagement
Both responsible and impact-driven investors will want their asset manager to engage with companies to improve corporate behaviour. From a responsible investor’s perspective this is a way to reduce risk and from the impact-driven investor’s point of view it is a way to improve society. This is easier for some asset classes than others. It is more straightforward for equities as shares also come with voting rights but much less obvious how investors can influence sovereign debt issuers.
- Conditional investment terms
For some impact-driven investors it is possible to shape investment terms to encourage improved investment behaviour. For example, a private debt investor can say a company can pay a lower coupon if it were to improve its ESG characteristics. This is in keeping with the impact-driven investors’ goal where below market returns can be tolerated if society is improved.
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