What Is Sustainable Investing – the BS Meter

THE DEFINITIVE GUIDE TO SUSTAINABLE INVESTING - PART 3

This article is part of Bankeronwheels.com definitive guide to Sustainable Investing.

There are four main types of sustainable investing. Below, we explain why we think differently than most. By doing so, we can try to exclude what’s the most intrusive part of Sustainable Investing – the ESG Ratings.¬†Now, let’s look at how, despite the irrelevance of ESG Ratings for impact on the planet, you can still invest in a socially-responsible way.¬†

KEY TAKEAWAYS

  • Screening of investments has existed for centuries. It’s simple to implement by removing investments not aligned with your moral values.
  • Such investing is called Socially Responsible Investing or SRI.
  • Wall Street made SRI complicated by blending it with exclusions based on ESG ratings that are irrelevant to the goal of most individual investors willing to protect the planet.
  • SRI & ESG blends represent the vast majority of options, but pure SRI ETFs are also available.
  • Finally, there is also a good choice of Impact funds, but these are more active investments.

Here is the full analysis

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RUNNING SUSTAINABLE INVESTING THROUGH OUR B.S. DETECTOR

Reinventing the wheel

You probably knew it –¬† Ethical investing isn’t something new. Judaism prevented followers from investing in immoral companies and Islam – alcohol or pork products. As ethically-minded investors, millennials want to eliminate investments that are in conflict with their beliefs:

  • Financing Controversial Weapons
  • Supporting Tobacco Companies or
  • Investing in Alcohol Firms, to name a few.

Investing in a broad index but removing some controversial stocks is called Socially Responsible Investing, or SRI. Some of us may not mind that this may have a negative impact on returns (separate article). But Wall Street made it complicated. 

Calling Wall Street's Bluff

You see, most ESG Ratings are irrelevant as it relates to protecting the planet.¬†Worse, these ratings are almost always backwards-looking. They can’t predict corporate controversies.¬†And yet, Wall Street bundled them together with SRI filters to make things less transparent. It finances the ESG Rating industry and justifies higher fees.

Maybe because investing solely based on ESG ratings, also called ESG Investing, wouldn’t attract as much money.¬†¬†Sooner or later, a website like ours would call Wall Street its bluff.¬†Finally, there is the holy grail.

Highly concentrated bets, e.g. related to clean energy, sustainable agriculture or investments aimed at solving a social problem, e.g. an underserved community, are called Impact Investing. The real stuff. Something that may make a difference for the planet.

Our Sustainable Investing Framework - Spectrum of Investments

Our Way of Thinking about Sustainable Investing

In summary, there are two criteria when thinking about Sustainability:

  • Whether there are SRI, or ethical / value-based security selections (#2 and #3 in the graph above)
  • Whether there are ESG-rating involved (#1 and #2 above)
  • The last one, Impact Investing (#4 above),¬†is slightly different, as we explain below.

Killing Portfolio diversification

Now, you get the picture. SRI Investing on its own makes sense. Blending ESG + SRI mainly does when ratings have a relatively low impact on the security selection. Here, at Bankeronwheels.com, we emphasize that diversification is key to long-term investing success.  Both ESG Rating exclusions and SRI screening impact diversification.

Of course, removing controversial investments with SRI through ethical / value-based filters reduces ETF diversification. But this is your personal choice. The problem becomes more pronounced when an ETF only retains, e.g. 25% of the highest ESG-rated companies in a sector, further impacting diversification. And here, no one asked you for your opinion.

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HOW TO THINK ABOUT SUSTAINABLE INVESTING

Planet Focus but avoiding ESG ratings

As you’ve seen, we developed our own framework for thinking about Sustainable Investing.¬†But let us also make something clear.¬†Pure ESG Investing (#1 on the graph above) shouldn’t be called sustainable investing.¬†¬†At least from a planet perspective.¬†It is called like that because if you look at MSCI or Sustainalytics definitions, Sustainability is defined as… Sustainability of corporate profits.

Degree of Reliance on ESG Ratings and Value-Based Exclusions in Sustainable Investing

ESG RATING BASED INVESTING

1. ESG INVESTING

  • Approach – Investing based mainly on selecting the highest ESG Ratings or excluding the lowest ratings.
  • Reliance on ESG Ratings¬†– ESG Ratings¬†do impact¬†ETF constituents.¬† The ETF can eliminate e.g. worst performing (bottom 25%) or, e.g. retain only the highest (e.g. top 25%)
  • Personal Values¬†– The investor does¬†not¬†express¬†her values¬†
  • ETF Landscape¬†– ETFs focusing only on ESG Ratings are relatively rare¬†

2. ESG + SRI BLEND

  • Approach – Investing based on ESG Ratings and value-based exclusions.
  • Reliance on ESG Ratings¬†– ESG Ratings do impact ETF constituents. The ETF can eliminate, e.g. worst performing (bottom 25%) or retain only the highest (e.g. top 25%)
  • Personal Values¬†– The investor does¬†express her values¬†
  • ETF Landscape¬†– There is plenty of choice of ETFs in this category. That’s why we put the ETF icon in the framework graph. Unfortunately,¬†it’s the trap/confusion zone for most investors.

NON-ESG-RATING BASED INVESTING

3. SRI INVESTING

  • Approach – Investing based only on value-based exclusions.
  • Reliance on ESG Ratings¬†– Ratings marginally or¬†do not impact¬†ETF constituents
  • Personal Values¬†– The investor does¬†express her values¬†
  • ETF Landscape¬†– There is some choice of ETFs in this category¬†

4. PASSIVE INVESTING

  • Approach – No exclusions.
  • Reliance on ESG Ratings¬†– Ratings do not impact¬†ETF constituents
  • Personal Values¬†– The investor does not express her values¬†
  • ETF Landscape¬†– Wide choice¬†¬†

5. IMPACT INVESTING (Not Represented Above)

Impact Investing is not included in this graph because it takes a very different approach (separate article) But if we had to run it through our framework:

  • Approach – Highly concentrated investments based only on planet/social impact goals¬†
  • Reliance on ESG Ratings¬†Financially-material ESG Ratings do not impact ETF constiuents
  • Personal Values¬†– The investor does¬†express her values because it focuses on addressing a specific environmental or social issue
  • ETF Choice¬†– There is plenty of choice of ETFs in this category¬†
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Different shades of 'Blend'

Of course, ETF selection is not all black and white.¬†¬†But without a robust intellectual framework, an investor can quickly get lost.¬†The ESG/SRI Blend is the land of confusion.¬†In the following articles, we look at these different shades of ‘blend’.¬†Can you use value-based filters while minimizing ESG rating impact?¬†¬†Let’s have a look at the different benchmarks.

Thank you for reading.
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