Investing with a Conscience
Environmental, Social and Governance (ESG) Investing
My introduction to Socially Responsible Investing began at church. Michael Jantzi, who was raised in the church where I was then a pastor in London, Ontario, and where his parents were still members at that time, came one Sunday from his base in Toronto to speak about the fruit of his work at Jantzi Research, a firm which evaluated companies’ sustainability performance. He had launched the Jantzi Social Index, an index first followed by Meritas Mutual Funds, a company started by three Mennonite organizations. This was followed by the iShares Jantzi Social Index Exchange-Traded Fund (ETF), XEN.
Jantzi Research has since become Sustainalytics, still headed by Michael Jantzi. Meritas Financial’s mutual funds are now a part of NEI Investments. And Socially Responsible Investing (SRI), also known as Responsible Investing (RI), Sustainable Investing, or more recently, Environmental, Social and Governance (ESG) investing, has moved far beyond the small Mennonite world into the mainstream of investing.
What is ESG Investing?
There are two basic approaches to this type of investing. For simplicity, I will adopt the description used by BlackRock, the owner of the iShares brand of ETFs:
- “Avoid” strategies involve the elimination of certain companies or sectors that are associated with increased ESG risk or which violate the asset owner’s values.
- “Advance” strategies focus increasing exposure to positive ESG characteristics to align capital with certain behaviours or target specific positive social or environmental outcomes.
An example of an avoidance or exclusion strategy can be seen in the description that BMO’s ETFs provide in their Benchmark Info regarding an Exchange-Traded Fund that provides investors with exposure to the Canadian stock market, ESGA:
- The Index excludes securities of companies that earn significant revenues from tobacco, alcohol, gambling, conventional weapons and civilian firearms, any controversial weapons, significant generation of nuclear power as well as companies involved in severe business controversies.
To understand strategies that advance ESG characteristics, we need to dig into what each of those letters refers to. I borrow the following definitions from the Netherlands-based, Japanese-owned asset management firm ROBECO:
- Environmental: Factors include the contribution a company or government makes to climate change through greenhouse gas emissions, along with waste management and energy efficiency. Given renewed efforts to combat global warming, cutting emissions and decarbonizing is become more important.
- Social: This category includes human rights, labour standards in the supply chain, any exposure to illegal child labour, and more routine issues such as adherence to workplace health and safety. A social score also rises if a company is well integrated with its local community and therefore has a ‘social licence’ to operate with consent.
- Governance: This refers to a set of rules or principles defining rights, responsibilities, and expectations between different stakeholders in the governance of corporations. A well-defined corporate governance system can be used to balance or align interests between stakeholders and can work as a tool to support a company’s long-term strategy. Governance can also refer to the standard of government of nations.
Is ESG Investing worth it?
First, the Bad News
There is always the possibility that ESG investing may have a detrimental effect on your investment returns. This can occur for at least three reasons.
If you take the indexing approach to investing, your goal is to have an investment return that mirrors that of the stock market less a small fee for the management of the fund. At least nine ETFs charge a Management Expense Ratio (MER) of less than one-tenth of one percent, a virtual rounding error. As I am not licensed to sell investments, I do not make specific investment recommendations, but in general I think that most would-be investors will do well to choose low-cost broad-based index funds. ESG Investing deviates from that kind of approach, although potentially only slightly.
If the Canadian stock market returns 10% in a given year and the all-in costs of investing in an ETF that tracks the stock market are 0.1%, if your return is 9.9%, then the tracking error is solely attributable to the costs. But what if you only get a return of 9.4%, an extra 0.5% less? That tracking error has something to do with the management of the fund. In the case of an ETF that uses ESG characteristics to deviate from the Canadian stock market tracking error is more likely. Mind you, tracking error can go both ways, in that sometimes you may underperform the index and other times you may outperform. Even so, the goal is to get the expected return.
In the ETF space, there are multiple Canadian equities that charge an insignificant MER of 0.06%. That is $6 on a $10,000 investment. Currently, the lowest cost ESG ETF I can find has an MER of 0.23%. That works out to $23 on a $10,000 investment. You may not be concerned about a $17 difference on a $10,000 investment, especially if your reasons for making these investment choices are not exclusively about getting the biggest return. However, over 20 years that small difference could grow to over $1,500 thanks to the power of compounding.
Lower Expected Returns
People choose ESG investments because they want to see responsible companies do well and less-responsible companies do less well or be forced to change some aspect of their business practices. This is more of a theoretical idea at this point because I am not sure how much impact ESG investing has had on the broader stock market yet. The idea is that investors who pour more money into investments that they favour will go up in price, while those that are “bad actors” by ESG criteria, will receive less investment money. They may be forced to borrow money at higher interest rates, for example. However, as a consequence of their price being forced down, these companies consequently have a higher long-term expected return, whereas those that have been bid up in price because they meet ESG criteria will have a lower long-term expected return because investors will be buying at a higher initial price.
Second, the Good News
ESG Funds Perform Comparably to Non-ESG Funds
No doubt the results depend on which funds you compare, but for the purpose of this blog post, I will compare ZCN, the BMO S&P/TSX Capped Composite Index ETF against ESGA, the BMO MSCI Canada ESG Leaders Index ETF. ESGA was only launched in January of this year so there is not a lot of data and most certainly does not represent long-term performance. In any case, over the most recent 6-month period, ESGA outperformed ZCN by 5.50% versus 1.54%, respectively, a difference of 3.96%. As time goes on and more data is gathered, we will be able to see whether this difference persists.
ESG Criteria May Drive Companies to Perform Better
ESG investing is not just about excluding bad companies. It is also about encouraging good performance. Instead of excluding companies, then, some investors, especially ETFs and mutual funds with ESG mandates, will vote their shares in a way that pushes an ESG agenda.
Reduction in Risk
BlackRock CEO Larry Fink wrote a letter earlier this year to the CEOs of major companies in which his company invests. In the letter he writes that he believes it is BlackRock’s fiduciary duty to its investors to recognize that “climate risk is investment risk,” and take appropriate initiatives to reduce those risks.
Lack of Clear Definitions: ESG is in the eye of the beholder
In my introductory words I lumped together SRI, RI, Sustainable and ESG as broadly about the same thing. Some will agree. Others wish to make finer distinctions.
To give you an example, I was scouring one ETF for its holdings. It seeks to track the US stock market while using ESG criteria. To my surprise, it included at least two companies that are heavily involved in military contracting. Another issue is that certain well-known tech companies are generally included in such funds because their business is quite “green.” They do not generate a lot of pollutants. They may also have a good corporate governance structure. However, their treatment of frontline employees may be questionable or their business model is otherwise problematic for society at large.
Surprise: ESG Investing is Not Less Difficult
It is not my intention to discourage ESG investing. I think it is a valuable contribution to the investing world and, on environmental concerns, I think that Larry Fink raises a significant point about the risks of failing to address such matters.
There are a few fund companies that provide ESG funds. Two of the biggest in Canada are BlackRock’s iShares ETF lineup and BMO’s ETFs. On the latter, do a Control-F search for ESG. A third company is Desjardins. I invite you to click on the links embedded in the names. There are other sources of ESG investments in Canada, including in the mutual fund world, but that will have to wait for another post.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax or legal decisions.