ESG first or „Responsible investments: No excuses left“

Even though returns and risks of traditional and responsible investments seem to be comparable, suppliers of traditional financial services often mention disadvantages of responsible investments such as limited scope of investment options, diversification restrictions and high costs for data and analysis. But that is mostly not true (see https://prof-soehnholz.com/esg-investing-20-false-arguments/).

The key questions are: What does “responsible” mean and how to best invest resonsibly (see Ihttps://prof-soehnholz.com/taxonomy-for-responsible-investments-avoiding-greenwashing/).

ESG first: Overview of „sustainable“ investment opportunities

Responsible investments can come in many forms:

Asset segment Examples
Savings products Microfinance savings account, eco savings certificate
Stocks Shares of companies with a good sustainability rating
Corporate bonds Bonds from companies with a good sustainability rating
Green/
Social bonds
Project bonds with an environmental/climate, social or economic development
focus
Government
securities
Bonds from countries with a positive sustainability rating
Funds Sustainability mutual and institutional funds including ETFs
Real estate Individual properties with sustainability certificate and real estate funds
Direct investment Renewable energy and other infrastructure projects
Forestry (Certified) Forestry investments
Raw materials Purchase of gold / silver e.g. with Transfair seal

Own analysis based on Institut für nachhaltige Kapitalanlagen (INK): Nachhaltige Kapitalanlagen für institutionelle Investoren, September 2017, p. 16

Many of these investment options have illiquidity risks and have been subject to other criticism, e.g. microfinance investments can drive borrowers into over-indebtedness and renewable energies may benefit excessively from public subsidies.  

ESG first: Make others rich without improving the world?

Responsible investments usually come in the form of equity or credit and suppliers of responsible investments typically want to make a profit or at least pay themselves decent salaries. That is perfectly ok. I rather want providers of sustainable investments to make money than suppliers of non-responsible investments. Also, many low-cost responsible ETFs are available now. They have some limitations, though.

Some people criticise that equity investors just buy stocks from sellers and therefore only enable the seller to make a profit and argue, that this can not be responsible investing. But in a society like ours, most initiatives would not be started without the possibility to generate profits. (“Early”) Responsible investors should profit from some investments since they also may lose money in many other (early stage) investments.

And a high demand for scarce responsible equity, even without a direct net inflow of capital, should lead to a higher valuation of the equity. That should facilitate future equity or credit increases and thus allow responsible companies to survive and potentially grow.

ESG first: Problems with exclusions

Responsible investments typically exclude “irresponsible” market segments. But there is little black or white because for many exclusion criteria opposing arguments can be found: Don`t we need weapons for internal security and external defence? Do we need fossil energy to keep electricity accessible for low-income groups and industrial production? Do we need nuclear energy because it produces energy in a climate-friendly manner? Can genetically modified organisms help to reduce hunger? Should we abandon all investments that support beef or dairy production because cattle are among the largest sources of CO2? Are animal experiments important for medical progress? Should gambling be legal because it generates a lot of tax revenue? Are alcohol and tobacco permissible as a „pleasure“ goods or should even retailers who offer them be condemned? Should plastic production be outlawed, although plastic is indispensable in many areas of life? Should one generally avoid countries that enforce death penalties such as the US?

Some investors would like to have exclusions that go even further, e.g. airlines, car manufacturers, travel operators, luxury good producers, fastfood chains, softdrikt producers, even banks etc..

There is no generally accepted exlusion standard: Every investor must answer these questions individually.

ESG first: Problems with best-in-class approaches

For fear of under-diversification or “tracking risk” to traditional benchmarks, investments that are the best in their „class“ are often included in a portfolio. But even best-in-class investments may have a relatively poor responsibility profile, such as the „best“ oil producer.

A “best-in-universe” approach does not have this problem. But selecting only best-in-universe stocks would lead to a portfolio which would exclude many market segments und thus reduce diversification. In addition, many ESG data suppliers generate only best-in-class and do not provide best-in-universe scores.

Investing in a single project, bond or stock is typically much riskier than holding a diversified portfolio. Sometimes it is criticized that responsible investment criteria limit the investment universe too much, so that a sufficient diversification can no longer be achieved. But many studies show that good diversification can be implemented with relatively few securities. And in most cases responsible investments are bought only as add-on investments, anyhow.

ESG first: The problem of aggregated ESG scores

And there are other possible problems for responsible investors. If securities are selected according to an aggregated evaluation, e.g. an ESG (Environment, Social, Governance) rating, securities that have a poor score in one of the dimensions E, S or G can be included in a portfolio if they score well in the other dimensions. That is not unusual: Most „responsible“ ETFs use aggregated ESG scores. But for demanding investors it is important to ensure that minimum requirements apply to each score.

Similarly, good projects or good securities, e.g. green bonds, may be initiated or issued by not so good companies who would not be able to receive traditional financing or would have to pay more for it. Consequently responsible investors should rather support good initiatives by good partners (see Soehnholz, Dirk; Frank, Ralf: Responsible investments: Proposal for an operational taxonomy, DVFA Sept. 2018).

ESG first or ESG only?

If the potential investment universe of an active portfolio manager is already small due to many “non-responsible” stock selection criteria, the addition of responsibility criteria (usually referred to as ESG integration) could in fact lead to a measurable reduction in diversification. But traditional security selection criteria such as tracking error limitations to benchmarks, minimum capitalisation and liquidity requirements typically restrict diversification much more than responsibility criteria.

If evidence is analysed correctly, it is difficult to prove that traditional selection criteria have more positive effects on portfolio performance than responsible selection criteria. Indication: The performance of indices that use (almost) exclusively responsible selection criteria (e.g. SRI or ESG indices), typically is comparable to traditional indices. Such „responsible“ indices can be defined as ESG only or pure ESG. In contrast, active traditional funds rarely outperform traditional indices and therefore will not systematically outperform responsible indices.

There seem to be no serious excuses left not to invest in a „ESG first“ responsible way.

Other topics of potential interest see https://prof-soehnholz.com/evidence-based-investment-analysis-new-first-online-trainings-available/ and /https://prof-soehnholz.com/evidence-based-investment-analysis-ebia-a-new-term-every-financial-analyst-and-investor-should-know/

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