Over the last ten years, the investment industry has seen a significant increase in the volume of assets managed under the ethical investment banner as more and more retail investors look to invest their money in companies that share their values and strive to have a positive impact on society by acting in a responsible and sustainable manner.
At the forefront of this movement, especially in the last few years, are millennials that have invested their funds with that interest in mind. During the same period, many mutual fund companies and Exchange-Traded Fund (ETF) providers as well as individual Investment Advisors have started offering investment solutions that cater to this growing demand. This is not just a consideration for retail investors either. Many institutional investors who represent our public and private pension plans as well as the asset managers of foundations and charities apply ESG—a type of responsible investment process—when making their investment decisions. When researching ethical or responsible investing, terms such as ESG and SRI will regularly, it is important to understand the differences between both.
What is ESG?
ESG refers to environmental, social, and governance factors that may have a material impact on an investment. Examples of environmental factors are the impact of a company’s activities on climate change, energy efficiency or water and waste management. Under the social factor are human rights, working conditions, the health & safety record and community consent. Lastly, under governance, the managers will consider corporate behavior, transparency and disclosure as well as the alignment of interests between executives and shareholders.
Asset managers and pension plans that espouse ESG will integrate those factors as part of their overall decision-making process when it comes to selecting individual securities. In their ESG analysis, they will assign a score indicating a high or a low risk rating, and poor or best in class practices. ESG is viewed as an additional risk factor that does not necessarily appear on the balance sheet and needs to be taken into consideration.
Worth noting is that firms that follow ESG may still make or hold investments in companies that rate poorly, but they will be able to better identify and understand the risks involved and manage them accordingly. It also means being a responsible owner by entering into a dialogue with the company’s management on ESG issues and exercising their voting rights to effect change.
What is SRI?
SRI stands for Socially Responsible Investing and involves using the ESG factors stated above to screen out or exclude investments based on a set of values. SRI investments may exclude securities based on an ethical or moral criterion, such as companies in the tobacco, alcohol, nuclear, firearm or other objectionable industries. SRI also uses ESG to positively screen out companies that are best in class versus industry peers while choosing not to invest in the laggards. This approach enables investors to choose investments that are consistent with their financial goals and personal values.
Additionally, in the case of SRI investing, if you choose to invest in mutual funds or ETFs, it’s important to visit their website and read up on the values they wish to project and their methodology for screening out investments. Some providers will place a greater emphasis on the environmental factors versus the social factors as an example.
An important difference between the two terms is that with an SRI you will hold ethical investments within your mutual fund or ETF because of the screening process provided by ESG, but nothing will be done to improve the companies that are excluded. With ESG investments, on the other hand, you could potentially hold investments that are rated poorly, but the firm managing your funds is engaging the companies on ESG issues with the goal of changing their behaviour. As an individual investor, you need to decide what type of goal you wish to achieve when trying to impact and support positive social or environmental outcomes with your investment dollars.
If you would like to find out more, please visit the Responsible Investment Association (RIA) website at www.riacanada.ca
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