ESG and SRI Investing - what is what?

One of the topic that is trending since some time relates to ESG investing or Environment, Social, Governance investing. Then you also hear a lot about SRI (Socially Responsible Investments) and Impact Investing. Today we try to bring some clarity and understanding on these acronyms and broader topics.

The idea behind ESG investing is to introduce a filter based on certain environmental, social and governance related criteria. For example, when it comes to governance, you would consider the diversity of the board and management team and the transparency of communication to shareholders. On the social angle, employees engagement and turnover would be looked at. Finally, on the environmental side, one could look at the use of renewable energy and recycling operations.

Companies (or ETFs) with better ESG scores should be able to manage better the risks in these areas and therefore offer higher returns in the long run (if you think about bag governance and its potential impact, think about VW and the dieselgate).

SRI - on the other hand - excludes investments in companies involved in weapons, tobacco, gambling, alcohol and more "controversial" activities.

In theory, one investment could pass the ESG criteria but not the SRI one. Think about a very well governed and socially responsible company selling alcohol: it could get very high ESG rating but be escluded a priori from SRI investing. I believe - though - there is mostly an overlap between these definitions.

Then, even more recent, I started to see references to Impact investing. Here the focus is to maximize the positive impact on society, rather than screening out investing in controversial businesses (like in SRI).

If you feel like in a jungle of acronyms, believe me - you are not alone. And to really understand what this all means, we are not even halfway!

One the source I found most helpful to orient myself is the website of MSCI. This website is a jungle by itself to be honest, but there are some (more or less) hidden gems:

They clearly explain how they calculate their ESG rating here. They use a scale from CCC (worst) to AAA (best) and they rank companies or ETFs relative to each other based on ESG criteria. The ranking is industry specific and the industry determines the key ESG risks: cybersecurity risk will be more important for a financial institution than for a mining company. Below is the rating system from the link above:

If you want to see the ESG rating of an ETF you can use this search tool (always from the same website). It is very interesting to compare the ESG rating of your ETFs - for example, the VWRL scores a AA with 33% of its holding being ESG Leaders and only 5% being ESG Laggards.

The most useful section though is for me the menu you see below - which you will find here (just remember to expand the "Custom Indexes" menu on the left in case):

What do I like about this? Well, everything is in one place and you can more easily understand the subtle differences in all the sub-categories of ESG and SRI investing.

For example, the MSCI SRI Index (4th from the top) targets the top 25% companies based on ESG criteria in each industry, while excluding or underweighting companies involved in controversial activities (e.g. firearms).

The MSCI ESG Screened Index (just below the previous one) excludes completely companies associated with nuclear weapons and tobacco or companies generating more than 5% of their revenues from thermal coal based power generation or companies that are not in compliance with the United Nations Global Compact (UNGC) principles.

MSCI Low Carbon Indexes try to minimize the exposure to risks related to the transition to a low carbon economy in two different ways: one suite of indexes "re-weight stocks based on their carbon exposure in the form of carbon emissions and fossil fuel reserves" while the second one "aim to achieve at least 50% reduction in the carbon footprint of the parent index by excluding companies with the highest carbon emissions intensity and the largest owners of carbon reserves".

MSCI Climate Indexes seem to take the Low Carbon Indexes approach and combine it with an "increase of exposure to companies participating in opportunities associated with transition". I believe this could be referred as an example of Impact Investing.

The bottomline for me is that if one is serious about ESG, SRI, Impact Investing - or however you want to call this - a fair amount of research is needed to understand what is behind the investment and see if it really corresponds to your personal beliefs and values. Just do that and if you end up in an ESG or SRI ETF, who cares!

We have not mentioned until now an obvious point - all of this reduces diversification. As mentioned before, we apply a filter to the broader portfolio, so it is natural for the diversification to go down. Also, it is unclear if in the long term ESG / SRI investments will outperform the overall market. And, last but not least, you are likely to face a higher TER than normal but the premium should not be that much.

If you want to learn more about different topics, click on the links below: