ESG: Investors Are Human Too
by P.E. Kelley
Mr. Kelley is managing editor of this magazine. Connect with him by e-mail: pkelley@lifehealth.com.As more investors begin to embrace and seek to understand, and ultimately invest in, emerging ‘environmental, social and governance’ portfolios (ESG), the industry has mobilized to deliver these opportunities in a way that makes sense to its clients. But that’s where things often get a little hazy, because socially responsible investors, who usually come to invest with good intentions, are not always best positioned to pick which societal issues they should care about. And when investment managers encourage investors to make this choice on their own, they could be doing them a huge disservice.
To complicate matters further, there is a unique psychological component to ESG investing as well: when it comes to socially responsible investing, clients at times tend to worry much more about the bad things that a company does and consider the positives less. In reality, of course, the positives are just as important.
James Katz is the founder and CEO of Humankind Investments. He spoke with Advisor Magazine about the explosive growth in ESG investment, how Wall Street has enticed investors to approach it with ‘their gut’ and how investment managers now have an added layer of responsibility and compliance. They must now take the time to research every possible issue so that they can understand its relative importance, and its impact on humanity, before they try to pick the right mix for their products.
PEK: Let’s start with consumer perception of ESG principles. How sophisticated are today’s investors that so many are demanding they be embodied in the funds they buy?
JK: People are starting to realize that if they only focus on the investment return in their brokerage statement, they’re missing out on the impact that companies can have in other areas of their lives as customers, employees, and members of society. For example, a tobacco company could be making money for us in our investment portfolio while getting our family members sick, forcing us to shell out money to pay for medical bills. If we ignore the impact that companies have on us as human beings we’re leaving a lot of real value on the table – companies could, in effect, be putting money in our right pocket as investors while taking money out of our left in other areas of our lives. People who don’t want to be responsible for hurting themselves and others through their investment portfolio are likely to look for ethical investment options that connect these dots.
PEK: Humankind has adopted the 6 UN Principles of Responsible Investment. What is involved in incorporating a third-party standard into the complexities of an investment manager’s policies?
JK: Humankind Investments is a UNPRI signatory. While the UNPRI does provide a big tent for all kinds of organizations to become signatories regardless of where they are on their social responsibility “journey,” transparency is one of their core principles – and I think that’s a good thing.
PEK: How did you conceive of your proprietary Humankind Value, which measures a company’s broad-ranging impact on its investors, customers, employees and society? Is it a measurement that can actually make a difference in investment performance?
JK: The idea for our Humankind Value metric stemmed from the basic principle that investors are never only investors – they are human beings. It can therefore make sense for them to take into account a company’s impact on humanity generally, not just on their investment portfolio. Humankind Value was created to try and quantify the human impact of companies. We felt that analyzing a company’s impact on those four core groups (investors, customers, employees, society) would provide a more holistic and balanced sustainability measurement.
In terms of the impact of Humankind Value on financial performance, the jury is still out – it’s a relatively new measure – and of course, past performance does not indicate future results.
PEK: Can you talk about Humankind’s humanity-first approach to building your portfolios?
JK: One of the benefits of having a quantitative measure of human impact is that there is a clear “red line” for exclusion – zero. When a company crosses that line and has a net negative impact on humanity, this means, based on our estimates and calculations, that the company is on the whole destroying value for humanity. In a situation like that, we feel justified in prohibiting purchases of that company’s shares. On the positive side of the ledger, we work to invest more in the companies that have more positive Humankind Values – our intention being to invest more in the companies making a positive impact.
PEK: Please share with us how Humankind embeds in its operations a process of engagement, a systematic outreach to companies within its portfolio to help them ‘improve their impact on humanity.’
JK: We work to reach out to the companies that we invest in, making ourselves available to have a meeting with a member of their team to explain how we assess their human impact and point out some opportunities for them to improve. Following that conversation, where we are able to establish that real improvement has occurred, this can increase their weight in our portfolio.
PEK: Humankind will then make the same outreach to companies not in its portfolio, to show how they might improve their operations to ultimately be included. Is this a successful strategy?
JK: The outreach to companies not in our portfolio is a bit different, but we do still try to make it happen. It’s still too early to tell whether this strategy will be successful, but there is good reason for companies to listen to what we say – if they do improve sufficiently, they have a chance to earn our investment. Regardless, reaching out to companies that we don’t invest in should work a lot better than completely ignoring them in terms of encouraging them to make a positive change.
PEK: Can you comment on the emergence of ‘greenwashing’ and the SEC’s attempt to clarify which funds, including so called integration-funds, are truly engaged with ESG principles?
JK: Our perspective is that the SEC should draw a distinction between funds that integrate ESG data purely to mitigate business risks (business-risk driven ESG) and those funds that use ESG data to try and invest more in more ethical companies (ethics-driven ESG). Making this distinction should help investors who are coming to the space for moral, ethical, and humanitarian concerns to avoid funds that work to invest in companies that are merely trying to shield their bottom lines from ESG-related consequences. For example, a business risk-driven fund may label a company that moves its factory from the coast to the mountains as earning an improved “E” score because its factory is now less likely to be flooded because of climate change. However, an investor who prioritizes “E” issues for ethical reasons, would likely want to invest more in companies that are trying to mitigate climate change itself (e.g. pollute less) – not specifically in those companies that are merely preparing for its impact on their business.
PEK: BlackRock’s former head of sustainable investing, Tariq Fancy, said in March that “sustainable investing is nonsense… government regulation is the only solution to society’s problems.” How do you combat such opposition to the emerging ESG marketplace?
JK: Well, I actually partially agree with Tariq here. There are certain brands of “sustainable investing” that he and I both think are nonsense. Furthermore, I do think that government regulation can be a strong force for good here in terms of regulating the bad guys and allowing the good guys to flourish. However, where we disagree is that government regulation is only part of the solution, not the whole solution – private investment, and socially responsible investing, has an important role to play, especially when government moves slowly. Also, just because some brands of sustainable investing are nonsense, that doesn’t mean that we should give up on the whole enterprise – rather, we should try harder to get it right, and be more careful about which partners we select to work toward our socially responsible investment goals.
I think that ESG offers a valuable way for shareholders to “vote with their pocketbooks” and in no way does what I am about to say discount that….
But thing that has always interested me was ESG as an Investment Strategy for superior risk adjusted returns. For example, a recent study by MSCI showed that companies with higher ESG scores provided higher risk adjusted returns than those with lower scores. I understand that the data is still in its infancy and that new studies have proven that there is not as strong of a relationship as the MSCI study proved.
It makes sense; an Energy company that is routinely violating EPA laws might have lax oversight in other areas that lead to underperformance. Obviously, this is an incredibly simple example, but I am interested in the returns of ESG relative to benchmarks in addition to the benefits of knowing that the companies in my portfolio are good corporate citizens.