Keep Calm and ESG

Were you forwarded this email? Subscribe here.

The news cycle has been heavy lately. COVID cases are rising, climate predictions are dire amid daily reports of fires, floods, and powerful storms, and the crisis in Afghanistan is leaving the rights and safety of millions hanging in the balance.

The good news is ordinary people are staying informed and looking for ways to make a difference. Google says searches for “how to help Afghan refugees” and “what can I do against climate change” were trending around the world this month.

As an investor, you can be a part of the solution as well. Your capital can back firms making a positive impact, reward those with good ESG behavior and give you a vote in shareholder campaigns or proxy proposals meant to bring about change. Remember, socially responsible investing makes financial sense, too. Companies with long-term views that factor in the well-being of all stakeholders are likely to be more successful and resilient when things go sideways. With the term “black swan” entering more vocabularies, this is a big moment for executives to display risk preparedness and farsightedness.  

However, investors need to stay vigilant about greenwashing and flowery press releases, especially since ESG ratings and disclosure rules are still fuzzy. ICYMI, Deutsche Bank may have just landed in hot water for overstating sustainability metrics on some investments. On the second anniversary of the stakeholder capitalism pledge signed by the influential Business Roundtable group, the jury is still out on whether they followed through. Harvard law professors looking for revisions in corporate documents concluded the entire exercise was mostly for show, but nonprofit JUST Capital argued that on average the signatories are actually treating stakeholders better than the rest. As we said, fuzzy.

Keep calm and carry on using screeners and other useful tools FWIW will be sharing. Clearer standards are on the way.

G is for governance

In discussions about ESG, governance usually takes a back seat to the more topical and pressing environmental and social impact themes. We also talk about it less because most of what goes on in hallowed halls is a tightly kept secret, and we learn about missteps and misdeeds in explosive scandals and leaks (or tweets, as is the case with Elon Musk). As we enter a new and confusing stage of the pandemic, good governance will be critical to steer through uncharted waters.

A quick recap: The “G” in ESG stands for everything to do with decision-making and leadership. Some prominent factors include executive compensation, company policies, shareholder rights, internal controls, corruption, management structure, the diversity of the board of directors, etc.

Key governance issues that have emerged lately are:

1. Vaccine mandates and remote work: Asking workers to prove COVID vaccination is a matter of employee safety and risk management to prevent shutdowns. Job listings mentioning vaccine requirements are already up 5000% since January, and full approval from the FDA is removing many of the legal worries about mandates. Still, major companies like Apple, Facebook, Wells Fargo, Chevron, and Amazon have already chosen to postpone the return to offices.
2. 2020 CEO Pay Increases: Top bosses at America’s biggest firms announced cuts to their base salaries last year, but their total compensation packages swelled. This is because stock options awards, which make up most of total pay and can be cashed in later depending on performance, were increased. Not a good look if you furloughed employees 👀.
3. ESG Risks: Yes, how meta. Corporations like Procter & Gamble and Clorox have recently warned shareholders that ESG scrutiny is a risk to their business. Execs increasingly know they can’t fumble this ball.

Mutual (fund) attraction

Did you swipe right on that 401(k) from your employer? If yes, chances are you matched with a mutual fund –– 66% of employer-sponsored plans include mutual funds. As we shared last week, mutual funds pool together money and invest it in assets to collectively produce a financial return over time. As of 2020, 718 mutual funds are taking ESG into consideration, representing more than $3 trillion.

However, just 3% of 401(k) plans have an ESG fund option, so it’s been difficult for many investors to invest in a values-aligned 401(k). That percentage is so low because regulations mandate plans to be managed to produce the best financial returns for their clients. It’s intended to protect employees from bad actors (or catfishers) with something other than making you money as their primary consideration. Since ESG commitments are technically considerations other than financial returns, employers are hesitant to offer them.

Of course, there are many compelling arguments that ESG is a valid consideration. ESG funds can actually outperform traditional mutual funds, and there is growing demand for the option; one survey found that 90% of people with 401(k) plans would invest in an ESG fund if it was offered. Given that there is nearly $7 trillion in 401(k)s, it’s a match with a lot of potential.

Now that the Biden Administration is looking to change the law to expand ESG fund access to more investors, cautious plan managers will be inclined to follow. Your next swipe could be a winner.

Avoiding the "bad" stuff

Anyone who takes great care to avoid the raisins or dried coconut in a bag of trail mix has performed a sort of negative screening. Now imagine what that looks like in investing. All investors seek financial returns, but their portfolios may look very different depending on their motivations and ethics. Impact investors, for example, back companies that improve people’s lives in demonstrable ways. Those who set the bar a little lower adopt a “do no harm” attitude, and use a method known as negative or exclusionary screening.

This is when you avoid businesses or industries involved in activities you disapprove of. Popular negative screens include tobacco, gambling, fossil fuels, animal testing, firearms, etc.

Negative screening is the earliest form of socially responsible investing. Going as far back as the 1700s, the Quakers in Colonial America banned members from participating in the trafficking of enslaved people in any way. The first SRI fund in 1971 was a reaction to the Vietnam War. Negative screening was being used to manage assets worth $15.9 trillion at the start of 2020, making it the second-most popular sustainable investment strategy. Today, experts say investors are also increasingly using positive or best-in-class screening and ESG integration.

If you’re looking to exclude, you can study individual companies, their revenue exposure to activities you dislike, and decide what your tolerance level is, or you can explore funds in the socially responsible category. For example, the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX) only includes companies on the index that do not own fossil fuel reserves.

Research has shown that screening tends to affect your returns and comes with risks, but sometimes it can actually help. The MSCI ACWI ex Fossil Fuels Index, which tracks the global market but excludes fossil fuels, has outperformed the broader market in eight out of the last 10 years.

Before you go -

Efforts to make Bitcoin’s smaller rival Ethereum environmentally friendly are underway, and those involved expect it will reduce the network’s energy use by 99.95%. Another “green” cryptocurrency called Cardano (ADA) surged this month after an upgrade announcement and is now the third-largest by market value behind Bitcoin and Ethereum.