As we look to the state of responsible investing, 2021 markets will require a vigorous due diligence process for ESG-interested investors.

ESG investing is “a strategy and practice of incorporating environmental, social and governance (ESG) factors in investment decisions and active ownership asset stewardship,” Brie Williams, Head of Practice Management, State Street Global Advisors, explained on the recent webcast, A Skeptical Investor’s ESG Due Diligence Toolbox.

Popular ESG Metrics

Common ESG considerations used in responsible investing that cover the environmental factor include things like water use & conservation, sustainable natural resources/agriculture, pollution/toxics, clean technology, climate change/carbon emissions, and green building/smart growth.

ESG considerations for the social factor include labor relations, workplace benefits, diversity & anti-bias issues, community development, tobacco & other harmful products, human rights, and executive compensation.

Lastly, the corporate governance factor includes corporate political contributions, executive compensation, board diversity, anti-corruption policies, and board independence.

“Trends bubbling under the surface for the last decade have come to a head, positioning ESG to transform from a check-the-box portfolio component to a significant component of a portfolio,” Williams said.

For instance, greater emphasis has been placed on social and governance factors after environmental factors had long dominated ESG conversations and investments. The investment landscape has changed drastically over the last decade, giving investors more solutions to satisfy a growing appetite for ESG factors in portfolios.  Additionally, large-scale wealth transfers from boomers to their children and a greater emphasis on living according to values have encouraged ESG adoption.

How Do Portfolios Incorporate ESG?

Suzanne Smetana, Head of ESG Investment Integration, State Street Global Advisors, highlighted five common methods of ESG incorporation.

  1. Exclusion/Negative Screening excludes specific companies, sectors, or countries based on ESG factors and/or to comply with values-based ideals.
  2. Positive/Best-in-Class Screening includes investment in sectors, companies, and countries selected for superior ESG performance relative to universe or industry peers.
  3. ESG Integration focuses on systematic and explicit inclusion of material ESG metrics into traditional investment analysis and decision-making process.
  4. Thematic Investing tracks specific ESG themes, such as climate/carbon, UN SDGs, health products, and human rights.
  5. Lastly, Impact Targeted investments aim at specific social and/or environmental concerns, most often with measurable aspects.

When doing your ESG due diligence, Smetana suggested that advisors ask managers for their ESG investment policy statements and leverage external partners like the UN PRI, TCFD, and other ESG organizations.

“Do your research, as there is growing, clear and compelling research suggesting a correlation between ESG and corporate financial performance,” Smetana said.

Financial advisors should also select a data framework that provides transparency around materiality, consider the value of using multiple data sources, and fully understand ESG scoring methodologies.

Evaluating ESG Data

Nicolai Lundy, Director of Partnerships and Market Outreach, Sustainability Accounting Standards Board (SASB), pointed out that not all companies are perceived equally, with smaller companies scoring less well on ESG metrics. Additionally, ESG scores are different across the various providers. Unlike credit ratings, ESG ratings also tend to exhibit very low correlation.

Lundy argued that ESG data and ratings are only as good as the source data, and without a industry-wide standard, the information reported by companies is policy-based, not quantitative. Consequently, only 11.6% of ESG metrics were performance data and only 1 of the top 25 disclosed metrics was numeric.

Lundy also warned that ESG quantitative data doesn’t guarantee comparability as even good-faith quantitative disclosures don’t always enable company comparisons. For example, various metrics are used to describe Employee Health and Safety for a random sample of 50 large, publicly-listed companies.

“Without data standards, companies use an array of metrics to describe the same thing,” Lundy said.

As a way to help investors tap into socially responsible investment opportunities, State Street Global Advisors offers a suite of socially responsible and ESG-related ETFs. For example, the SPDR S&P 500 ESG ETF (EFIV) enhances both SPDR’s ESG and S&P 500 ETF offerings, helping investors incorporate ESG while achieving a risk and return profile comparable to the S&P 500. The ETF tracks the S&P 500 ESG Index, which is designed to measure the performance of securities meeting certain sustainability criteria (i.e. criteria related to environmental, social, and governance factors) while maintaining a similar overall industry group weight as the S&P 500 Index.

The firm’s SPDR S&P 500 Fossil Fuel Free ETF (SPYX) tries to allow climate change-conscious investors to align the core of their investment strategy with their values by eliminating companies that own fossil fuel reserves from the S&P 500.

The SPDR Kensho Clean Power ETF (CNRG) seeks to provide exposure to the clean power industry in terms of both generation and underlying technology. Alternative energy sources are an increasingly important part of the power generation conversation.

Finally, the SPDR MSCI ACWI Low Carbon Target ETF (NYSEArca: LOWC) targets the MSCI ACWI Low Carbon Target Index, which tries to address carbon exposure by overweighting companies with low carbon emissions relative to sales and per dollar of market capitalization, as compared to the broader market. LOWC was created for the U.N. Joint Staff Pension Fund.

Financial advisors who are interested in learning more about ESG investments can watch the webcast here on demand.