3 Frameworks for Sustainable Investing
Sustainable investing isn’t a niche strategy any more. As millennials and Gen Z become asset owners, more investors want to build portfolios that match their values. Approximately 84% of investors worldwide want to promote sustainability, according to the U.N. Financing for Sustainability Development Report. And in the U.S., the number of managed assets in social good funds has increased by 38% since 2016.
Are the financial advisors in your wealth management firm prepared to meet this demand? There are several different ways to evaluate an investment to determine its fit in a sustainable portfolio. Here’s what advisors need to know about the trending triple bottom line.
Types of Sustainable Investing
There are no specific guidelines that define what makes an investment sustainable. But there are several frameworks for screening an investment. These include ESG, SRI, and impact investing.
ESG stands for environmental, social, and governance practices of a company, and this is the broadly accepted base standard for a sustainable portfolio. In this framework, investors evaluate a company by its environmental, social, and governance practices. The company’s performance in each of these areas becomes part of a more traditional financial analysis, using an approach called ESG integration.
For example, an environmental analysis would look at a company’s impact on issues like pollution, climate change, resource conservation, and animal welfare. Companies with clear environmental standards and goals are a better investment by ESG standards. A company that has a clear and progressing plan to transition to 100% renewable energy for its operations would be a strong investment in the environmental category.
A social analysis looks at a company’s practices regarding public health and safety, child labor, human rights, and community engagement. A company could demonstrate social responsibility by hiring for diversity, using ethical sourcing of materials and goods, and taking a public stand on human rights issues. Social sustainability also includes issues like employee rights, training, and safety practices.
A governance analysis evaluates the sustainability of a company’s structure and leadership. Issues to look at include executive pay, conflicts of interest, board structure, and transparency. For example, a company that limits the gap between CEO and employee salaries is a better ESG investment than a company with significant income inequality.
However, ESG investing always evaluates these issues along with financial risk. The core goal of an ESG investment, as for a traditional portfolio, is financial growth. And because it looks at financial risk first and values second, ESG investing usually offers a reliable financial return.
For investors who are deeply committed to social impact, the SRI framework puts values first. SRI stands for socially responsible investing, and this approach makes an individual investor’s values the most important factor. Unlike ESG, which integrates sustainability factors with financial ones, SRI investing uses sustainability as a filter. Often, an SRI portfolio will eliminate entire categories of investments for ethical reasons. For example, an SRI portfolio might avoid all fossil fuel and tobacco companies.
SRI is attractive to values-driven investors because it can be highly personalized. ESG evaluates by a broad set of general guidelines, but SRI can filter according to an investor’s individual principles. And because it seeks to balance social values with financial priorities, SRI can offer a good financial return.
Impact investing goes a step further than SRI by making values the most important factor. In impact investing, the goal of the investor is to achieve a specific social impact. Financial return is secondary. Impact investing could mean investing in a nonprofit whose mission aligns with the investor’s goals. It could also mean investing in a specific social industry, such as an entire portfolio focused on the renewable energy sector.
Impact investing is a blend of philanthropy and traditional investing. In this framework, social impact is the goal, and financial return is less important. For financial advisors, it’s important to understand the social measures an investor cares about when discussing the return on an impact investment.
Sustainable Investing Approaches for Financial Advisors
Sustainable investing can mean a shift in how ROI is measured. For some investors, ESG gives both a good financial return and a good feeling about their social impact. For others, SRI ensures their money never supports companies that conflict with their values. For still others, impact investing lets them leverage wealth to create social change. Advisors need to know how to communicate both financial and social return for each type of sustainable investing.
Choosing the right investments for a sustainable portfolio depends on an investor’s goals. The leading ESG categories in 2018 were climate change, tobacco, conflict risk, human rights, and transparency, but the best categories vary for each investor. Financial advisors should be prepared to discuss their client’s values on issues from social justice to the environment to morality.
Most importantly, financial advisors need to understand how sustainable investing supports both social and financial goals for investors. Being able to offer the right framework for a portfolio enables advisors to help investors grow both their wealth and their impact. And as the sustainable investing trend continues to grow, wealth management advisors that understand its value will also thrive.