How to create your own ESG-driven investment portfolio

Environmental, Social and Governance (ESG) based investment approach is about avoiding or reducing  exposures to companies that score poorly on these parameters and increasing the same in firms that do well on those parameters. For example, a company that runs several coal-fired power plants is likely to score negatively on environmental attributes. Another firm that helps the poorest section of the population with access to credit is likely to score positively on social parameters.

ESG has arrived on the global stage

Till 2015, ESG investing was a niche domain, with annual inflows in assets under management (AUM) of less than $ 10 billion. Since then, the AUM under ESG mandate has jumped rapidly – AUM inflows in 2019 were as high as $ 75 billion. The COVID-19 pandemic further boosted the appeal of ESG investing, as investors poured in a record $175 billion in it. The AUM influenced by ESG data is larger still – if one were to include standard investing mandates with ESG constraints. By some estimates, nearly $ 40 tn of assets globally are influenced by ESG data.

The unusual clubbing of E, S and G

Outside of investment world, environmental science and social sector studies do not quite go hand in hand. Governance is yet another domain in itself. However, inside the investment world, ESG has become a bit of a catchphrase. These attributes may have been ignored by investment managers in the past. Nevertheless, it is a welcome change that ESG is even thought about now.

Europe is at the forefront of this change. More than half of institutional money managed in Europe is already ESG-compliant. Nearly a third of investments in the US is also governed by sustainability requirements. Retail investors too are becoming aware of ESG attributes.

ESG is not exactly an investment strategy

Unlike well-known investment strategies such as ‘deep value’ or ‘equity market-neutral’, ESG is not exactly a specific investment strategy. It is more of an overlay applied to an underlying strategy. For example, if one starts with a simple index and applies an ESG overlay to it, one gets an ESG-compliant Index fund. The starting point can alternatively be a value or momentum strategy.

The ESG overlay itself can be applied in one of three ways.

-Negative list: Remove a given set of companies that are known to score poorly on one or more of the ESG parameters.

-Positive list: Invest only in a specific sub-universe that has positive scores on ESG parameters above a threshold.

-Tilts: Do not change the starting universe of the underlying strategy; instead, alter the relative weights of various stocks – increasing them for positive scores on ESG and reducing them for negative scores on ESG, both proportionately.

Why bother?

The idea behind investing in ESG-compliant stocks is that there is more to running our economy than just making profits. Till recently, companies saw their shareholders as the only relevant stakeholders and sought to maximize shareholder wealth. Initially, this seemed to be a sensible approach. However, there are a few reasons why this approach started to alarm people.

-Companies often went overboard in the pursuit of profits, thus damaging ecosystems, causing pollution and also exploiting human populations (typically away from their home countries).

-Sometimes, companies resorted to semi-legal or illegal practices to generate profits. Even the law-abiding ones often followed only the letter of the law and not its spirit.

-The very business models of several companies started to seem unsustainable from an overall social perspective. A well-governed coal-based power generator is technically doing nothing wrong by producing electricity from coal. However, the negative externality of this on the environment is huge. The cost is paid by the entire humanity in the form of global warming.

Investors that choose to invest using ESG metrics are essentially telling companies that they need to clean up their act on all these parameters. It is an attempt to influence the behaviour of the companies through the one stakeholder they listen to most – their shareholders!

Won’t it reduce returns of one’s portfolio?

While one may think that investing with the ESG constraint is likely to reduce returns performance of an equity portfolio, in practice, this is rarely the case. There are various reasons for it.

-The main reason is that many companies are actually fine on ESG counts. If you leave aside the major polluters and the worst-run companies, you are still left with a fairly large subset of the investment universe.

-Second, having a high ESG score is actually good for business in the long run. This is clearest for the governance angle. Companies that have clean accounting practices tend to be transparent. They typically do not experience shocks to their stock price on account of under-delivering on false promises of growth in the past.

-As more and more investors become aware of the ESG attributes of their investments and start to refine their portfolios to reflect these scores, companies that are placed higher on these will tend to perform better than those that are lower on scores – in terms of their stock price. This is somewhat of a self-fulfilling prophecy. However, as it will play out over many years instead of months, one can still benefit from it!

Where do I find ESG funds?

There are a few funds that exclusively focus on the ESG attributes of their holdings. There are some fund houses that claim that most of their funds are ESG compliant. An investor can choose to go with either of these options. However, the most reliable and transparent way to keep your portfolio ESG-compliant is to design it yourself. For this, you will need an advisor or a data provider that can tell you the ESG score of various companies in your investment universe.