By Harvest ETFs
Investors are flocking to investment funds that claim an Environmental, Social and Governance (ESG) mandate. According to a Deloitte study from April of 2022 projected that by 2024 half of all managed assets globally will have an ESG mandate. But what actually is ESG? The answer is more complex than it might appear.
While it has become arguably the most popular term for investments designed to reflect investor values, ESG is only one category in the wider universe of values-based investing.
Values-based investing has struggled with a persistent problem for its entire history: different investors have different values. Interestingly, values-based investing began with religious investors who wanted to avoid ‘sin stocks’ in their portfolios: things like tobacco, alcohol, pornography and weapons that didn’t align with their religious values.
Those first values-based investment funds and portfolios were constructed with exclusionary screens, eliminating companies and whole sectors based on the value-set being used. The aforementioned religious funds might screen for ‘sin stocks,’ while a newer environmentally conscious fund might screen out the fossil fuel sector. This exclusionary approach is called socially responsible investing (SRI).
SRI, however, suffers from the same issue of subjectivity that also plagues the wider world of values-based investing. ESG strives to address that issue by making the subjective a little bit more objective.
The Intention of ESG
ESG is not a static state, it is a process. ESG is the process by which potential portfolio holdings are assessed on the basis of their environmental impact, their role in society, and their internal governance. A company’s measurable metrics like their carbon footprint, relationships with community organizations, and internal diversity, equity & inclusion policies are collected by an ESG ratings agency. The agency tries to collect as many datapoints and paint as fulsome of a picture as possible, assigning that company an ESG score.
While an ESG portfolio may eliminate certain companies based on their scores, similar to SRI, certain ESG portfolios will also include some lower scoring companies which are working towards improving their overall ESG scores. Portfolio managers will further support this by using the shares of the funds they now own to advocate for more ESG-friendly policies at the company in a process called proxy voting.
So unlike SRI, which is entirely exclusionary, ESG is a mixture of inclusionary and exclusionary. The somewhat poor delineation between SRI and ESG, though, results in a perception problem among investors.
The perceptions and pitfalls of ESG
Many investors perceive ESG to mean SRI, or Values-Based investing. That’s not their fault per-se, ESG is a relatively new process and it’s often marketed ambiguously. But some investors are already wary of ‘greenwashing’—making something appear more sustainable than it is—in a wide range of industries. They will then look at an ESG portfolio and see a fossil fuel company listed in the holdings. The inclusionary side of the process explained above answers the question of why that company is included, but it’s also easy to see why an investor might be shocked at that holding.
Even though the ESG process strives to make values-based investing more objective, there will always be some subjectivity in this space. We believe it’s important that investors’ perceptions are met, however, by the product they’re investing in. Which is why the new Harvest ESG Equity Income Index ETF is constructed through SRI screens before an ESG scoring process is used in the screened universe.
Many investors want their investments to reflect their values, and it’s important for investment fund providers to meet that desire. We at Harvest ETFs have striven to follow a structured and easy to understand process in creating our ESG ETF so investors can understand how the portfolio holdings were arrived at.
It’s also important for investors interested in ESG, SRI, or values-based investing as a whole to inform themselves, which is why we’ve created this helpful infographic below.