Chapter 38
Socially Responsible Investing and Environmental, Social, and Governance Factors

Environmental, social, and governance (ESG) issues, socially responsible investing (SRI), and activist investing are driving major changes in the process of asset valuation, and are already influencing investing patterns, access to capital, and in some cases corporate operating performance. Whether the issues are of importance to you on a personal basis or not, they must be considered on an investment basis. Definitions are evolving in this arena and what can be considered socially responsible investing to one organization may be viewed very differently in another. ESG can be viewed as a risk mitigation tool that can be utilized for active investment decisions and should be part of all prudent investment decisions. SRI and impact investing are more of a stylistic decision that can utilize ESG data as well as other factors and SRI can materially impact the opportunity set for an investor. Stylistically impact investing is somewhat different, as it attempts to drive change in behavior around SRI or ESG issues.

ESG has become important due to scientific, sociological, and technological transformations. Concern over the environment has been steadily growing over the last several decades. This has been accompanied by more scientific evidence about environmental issues on a myriad of topics. Social issues have also been increasingly relevant as evidence has shown the economic (and moral) advantages of treating customers, employees, and counterparties fairly. Proper governance of corporations and organizations has always been important to investing but a period like the great recession highlighted these issues. Any bad behavior on these topics is increasingly captured through activist digital media outlets that are so prevalent and can quickly transmit and reach a large enough audience to hurt a company’s business. The ramifications of corporations failing on critical ESG factors can result in limited access to capital, loss of customers, government fines and higher legal and operational costs. It is vital to manage and monitor these risks when investing.

Companies must be aware of all facets of its operations to avoid ESG risks. These concerns can be harder to manage if a company grows rapidly and as the use of supply chains and outsourcing increase. Apple faced issues when its contract manufacturing partner Foxconn had problems reported about the treatment of its employees. Apple had to quickly respond to this indirect social problem as if it was its own and it rapidly and successfully changed things at its partner. Governance should always be a major part of any analysis, how a company is managed and how it is organized, this has to include understanding what checks and balances it has in place. This must include all aspects of its operations even if it means checks on its vendors and suppliers.

ESG analysis helps an investor to understand all the risks of an investment and these can be balanced against the potential rewards. SRI may limit certain investment outright or actively seek to overweight certain types of assets. SRI can be designed enumerable ways to reach specific goals that are important to an investor. For example, an SRI strategy may focus on a broad diversified portfolio but with no fossil fuels and a minimum of 10% allocation to renewable carbon free energy sources. You could argue that SRI decisions are driven by factors beyond pure financial issues, though an investor with an SRI strategy may disagree if they believe that a type of company is doomed to become extinct because of SRI issues in its business. Just like different investors may disagree about how much to weigh certain investment metrics in the decision process, investors may have different views on what are important SRI issues and what tolerances to accept.

There are an increasing number of styles of activist, or impact, investing. In these cases, investors use their capital to influence how a company acts on ESG and SRI issues. This is typically through pressures on the board and perhaps even through threats of proxy fights to wrest control from existing management if changes are not made. It can also come in the form of more cooperative engagement with management. In other arenas groups have pressured government to change certain issues, such as quotas for female representation on the board of directors; rules have been put on these issues in some places such as in France.105 Green bonds, that reward a company with better lending terms if certain ecological targets are met, can also be considered a form of impact investing. Whether any of these issues are important to you or not, they will impact the returns on investments and may impact the ability of a company to survive. When these factors are big enough risks there will be fewer investors to supply capital and there may be a backlash from customers. Some fund managers have become very active in impact investing and ban investments in some areas under SRI policies; it is unclear yet how this is impacting long-term performance so far. Initially it is likely that studies in this area will be run by people that have invested into using ESG and/or SRI systems so there may be some confirmation bias in the research. However, whatever the studies show, ignoring ESG and SRI factors is not a prudent approach because it is influencing capital flows.

In some cases, SRI positions are being taken by pension funds, which have certain fiduciary responsibilities to protect and grow the money it manages for current and future retirees. It may become an interesting debate as to what legal obligations a pension manager has should it choose to follow a set of moral standards with its investments that its membership may not agree with. The plan’s beneficiaries could challenge the management on whether this SRI policy is actually in the best interests for preservation of capital and growth of the capital base that employees have contributed for their retirements.

Everyone can undertake economic activism, and it is likely to become more common as people become more financially literate and realize the power of economics. Nations have realized this for some time, from historical blockades to modern day sanctions and tariffs. These techniques can work at the consumer level as well. Economic activism can be more quickly mobilized now than in the past and when a company has a misstep it will need to undertake more swift corrective actions. If you, as a consumer, do not like the way the American National Football League is handling brain injuries or are upset about safety at Formula 1 races, you could write nasty letters to the television networks and tell them they must stop showing them. They will likely not listen. However, if you organize enough people and get them to stop watching, it may have more impact, and then if you get all these people to stop buying the products of the sponsors of the sports, it may get an even larger response.

You do not fully understand the risks of investing if you ignore ESG, SRI, and activist investing. It is a reality that is influencing asset valuations and cash flows and will become increasingly important. It will evolve as a field, and digital media is likely to accelerate the impact of these factors.