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July 2020 – What is ESG, and is it Right for You?

Some people want to make investing a source of social change. Is that possible? If so, then what’s the best way to do that? Let’s look at theory and
existing research to see what options are available, and consider the costs and benefits of each.

What is ESG? The acronym stands for Environmental, Social, and Governance. But what does that mean, in practice? If you search the internet,
you’ll find that no generally accepted definition exists. In fact, ESG investing assumes different names and sometimes, those names mean different things to different people. For example, “responsible investing,” “socially responsible investing,” and “sustainable investing” are common. Some people make distinctions among these three, but the distinctions aren’t consistent.

Under this broad ESG umbrella you’ll actually find three broad categories. The first category is socially responsible investing. The Chartered Financial Analysts Institute defines this as, “avoiding morally questionable activities.” Note that this is passive. By this definition, ESG investors are much like teetotalers who personally avoid alcohol but do not seek to coerce or persuade others to do so. The second broad category is shareholder activism. To extend the analogy, the activist investor goes a step further, he is akin to the teetotaler who also inveighs against alcohol, or the local authority who enforces public intoxication laws. An example would be shareholder activists who vote their shares in support of “green energy” and often attend shareholder meetings to try to persuade others.

ESG is also considered a category unto itself that constitutes a third category within the broader ESG umbrella. Generally, ESG investing means that investors and financial managers identify investment risks and opportunities by considering environmental, social, and governance factors. For example, an investment manager with an ESG mandate might be expected to consider whether an oil company could face additional restrictions on energy development, depending on the outcome of an election. It’s certainly worth considering whether society might decide that nuclear power is safer than generally thought and invest in the nuclear sector. That would make electricity cheaper, so people would use less oil.

The key to ESG is that it specifically addresses risk management. According to the CFA Institute, risk management is what distinguishes ESG from socially responsible investing and shareholder activism. This is important because the number one reason managers give for considering ESG factors is in order to avoid risk that could lead to disastrous returns. This goes beyond simply excluding certain companies from a portfolio based on distasteful business practices because it explicitly incorporates ESG considerations when considering risk. MSCI Research for example defines ESG investing as “the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process.”1 Another example is a firm called ADEC Innovations, which embraces The Financial Times Lexicon. This defines ESG as ‘a generic term used in capital markets and used by investors to evaluate corporate behavior and to determine the future financial performance of companies.’”

Also In this Issue:

Quarterly Review of Capital Markets
The High Yield Dow Investment Strategy
Recent Market Statistics
Dow Jones Industrial Average Ranked By Yield
Asset Class Investment Vehicles