Sustainable investing ABC

ESG (Environment, Social, Governance) is a common abbreviation for sustainable investing, meaning that investors take into account how companies manage their ecological, social and governance risks.

Sustainability defined

The concept of sustainability is usually defined as one generation satisfying its needs without compromising the ability of future generations to meet their own needs. Apart from the environmental aspect the concept also includes social and economic aspects. 1

The different sustainable investing strategies

The different ways to take into account ESG aspects in the asset management process are commonly sorted into three broader categories: Negative screening, Positive screening and Engagement. Negative screening is when an investor excludes companies from the investment universe based on ethical criteria or international norms. Positive screening can be further categorised into ESG integration, Best-in-class, theme investing and impact investing, bur they are all strategies for choosing sustainable companies into the portfolio. Engagement is about influencing companies in a sustainable direction, for example voting as shareholders or meeting the company’s management to discuss a certain sustainability issue which the company can improve.

The difference between ethical and sustainable investment strategies

The term ”ethical” often appears as a variant of sustainable investments. Ethical usually suggests that the fund manager excludes companies that produce or trade, for example, weapons, tobacco, alcohol, gambling and pornography; i.e. sectors which according to the traditional Western norm are regarded as “unethical”. One focuses on what the company produces. Instead, responsible and sustainable investments identify risks in terms of sustainability and selects companies that manage them adequately. The latter concept therefore focuses more on how rather than what the companies produce.

Return in sustainable investments?

A constantly recurring question is whether fund managers’ customers need to forgo return vs. risk in favour of sustainability. In these discussions the reasoning that an investment must be sustainable in order for it to eventually create value is often presented. Several large studies have shown that sustainable investments do not result in a lower yield compared to investments with no regard to sustainability. There are also studies that conclude that certain types of sustainability strategies provide higher returns than investments that do not take into account sustainability. For example, Cortez, Silva and Areal (2009)2 show that sustainable investments in Europe have performed better than their counterparts in the US. A likely explanation, according to the study, is the use of various investment strategies; the US mostly uses exclusions, whereas Europe uses more methods such as norms-based screening and active engagement. This indicates that there are differences in yield potential between the different strategies and that a more active approach to sustainable investment than solely exclusions can pay off.

1 World Commission on Environment and Development, WCED.
2 “Socially Responsible Investing in the Global Market: The Performance of US and European Funds” University of Minho (2009, Cortez, Silva and Areal)