Sustainable investing is surging. How to decide if it's right for you

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Socially responsible, or sustainable, investing — investing in ways to make the world a better place — continues to surge, driven by increasing consumer demand and the recognition that sustainable funds provide returns comparable to traditional funds in addition to lower risk.

The first half of 2020 saw a record $20.9 billion flow into sustainable funds, almost as much as all of 2019, according to Morningstar. This continues a trend reported by the Forum for Sustainable and Responsible Investment showing U.S. sustainable investing assets at $12 trillion in 2018, an amount 38% higher than 2016. Only 25% of these assets were held on behalf of retail investors.

A tidal wave of growth is poised to follow in the retail sector, as just 25% of individual U.S. investors know much about this investing approach, according to a Morgan Stanley survey.

The attractiveness of sustainable funds' reward and risk characteristics will only grow. Another Morgan Stanley report found that, from January 2020 to June 2020, U.S.-based sustainable equity funds outperformed their traditional peers by a median of 2.8% in terms of total returns and likewise lost 3.9% less during this time of pandemic-induced volatility.

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As it has evolved, sustainable investing has grown into a complex landscape with sometimes confusing and overlapping terminology. Adjectives like "socially responsible," "socially conscious," "green" and "values-based" investing have coalesced into two main descriptors: sustainable investing and ESG.

Sustainability within an investment context is about meeting present needs while also considering long-term positive outcomes. ESG refers to three sets of overarching factors — environmental, social and governance.

As sustainable funds are marketed in varying ways, it's simplest to consider them in terms of the factors (and sub-factors) on which they focus and the strategies they follow, as identified by the Forum for Sustainable and Responsible Investment.

Just what is ESG?

There is no agreed upon definition of "E," "S" and "G," but they tend to be in the same ballpark.

Research firm MSCI breaks down ESG factors and sub-factors this way:

• Environmental: climate change, natural resources, pollution and waste, environmental opportunities
• Social: human capital, product liability, stakeholder opposition, social opportunities
• Governance: corporate governance, corporate behavior

Similarly, the Forum uses the following factors and sub-factors to screen funds:

• Environmental: climate/clean tech, pollution/toxics, environment/other
• Social: community development, diversity and equal employment opportunity, human rights, labor relations
• Governance: board issues, executive pay

In sustainable investing, these factors are incorporated into the traditional investment analysis by a process referred to as ESG factor analysis.

"Over the past 30 years, sustainable investing has evolved into a big data-driven ESG factor-analysis process," said Steve Schueth, managing director of Thrize Partners, a Boulder, Colorado-based sustainable investing consultancy, and former 20-year executive producer of The SRI Conference. "All the approaches are underpinned by this same process.

"If you cut through all the marketing stuff, you'll find ESG inputs," he added.

Two broad strategies

There are two broad strategies relating to sustainable investing, according to the Forum: ESG incorporation and shareholder resolutions/investor engagement. (See graphic below of the Forum's screening matrix.)

1. ESG incorporation: This includes these five common sub-strategies:

Positive/best-in-class screening: investment in sectors, companies or projects selected for positive ESG performance relative to industry peers. This also includes avoiding companies that do not meet certain ESG performance thresholds.

Negative/exclusionary screening: the exclusion from a fund or plan of certain sectors or companies involved in activities deemed unacceptable or controversial (such as alcohol, animal mistreatment, defense/weapons, gambling, tobacco, etc.).

ESG integration: the systematic and explicit inclusion by investment managers of ESG factors into financial analysis.

Sustainability themed investing: the selection of assets specifically related to sustainability in single- or multi-themed funds.

Impact investing: targeted investments aimed at solving social or environmental problems.

Impact investing in reality means positive impact. It's the intentionality behind the whole thing.

Steve Schueth

managing director of Thrize Partners

The term "impact" can be ambiguous, Schueth said.

"All investing has an impact, but are you paying attention [to what it is]?" he said. "Impact investing in reality means positive impact.

"It's the intentionality behind the whole thing," he added.

Further, impact investing is what's happening outside of Wall Street, said Michael Kramer, managing director of Windsor, California-based Natural Investments. He cites investing methods such as private debt and equity, venture capital, community development investing, banks and credit union and loan funds with a social purpose (for example, alleviating poverty).

"It's very solution focused, very proactive – often investing in innovations, and supporting social entrepreneurs and socially focused start-ups," he said.

2. Shareholder resolutions and investor engagement: ESG-related shareholder resolutions have focused on issues such as corporate political activity, climate change, labor and equal employment opportunity, executive pay and human rights, according to the Forum. Engagement refers to other manners of communication with companies, such as voting proxies, talking with management or joining shareholder coalitions.

The sustainability mindset is something most investors already have on an individual basis, said Meg Voorhes, director of research for the Forum for Sustainable and Responsible Investment.

"Why do people invest?" she said. "You're deferring immediate gratification.

"You're thinking long-term — about your education, your children's education, retirement — things that are 10, 20 years off," Voorhes added. "With sustainable investing — you're thinking about your hopes for the next generation and about — what do you want the world to look like?"

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