Sustainable Investing

Sustainable, responsible and impact investing involve investment disciplines that consider environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact. The idea of sustainable investing is not new, and many investors relate the term to socially responsible investing, which traditionally has involved screening tactics that exclude companies and industries on a basis of moral values (e.g. alcohol consumption, gambling).

Sustainable investing is now evolving beyond exclusionary screening based on a narrow range of criteria. Today, greater emphasis is placed on which companies to include, rather than exclude, from a portfolio, giving rise to a range of complementary approaches that can be used to implement sustainable investment strategies.

Long viewed as a niche asset class catering to wealthy individuals and institutions that wanted to avoid controversial industries such as tobacco and firearms, sustainable investing is becoming increasingly popular. Mainstream financial firms such as BlackRock and Goldman Sachs have introduced investment vehicles that take into account environmental, social and governance (ESG) factors. At the same time, a growing body of research has helped dispel concerns that investors have to sacrifice returns to do good.

Sustainable investing has also grown tremendously in the United States in recent years, with assets under professional management more than doubling from 2012 to 2016. This trend continued in 2016, and we believe it will persist. Total assets under management for sustainable investing in the U.S. reached $8.72 trillion in 2016 — roughly one out of every five dollars under professional management (Forum for Sustainable and Responsible Investment).

Many forces are driving this growth, including increased awareness that ESG factors may have a positive impact on performance and changing demographics, as millennials consistently express greater desire for some sort of sustainable investing solution. Also at work are changing social norms and the political polarization in the United States, leading some investors to want to see their social views represented in their portfolios. Some investors and financial professionals are skeptical of sustainable investing because, intuitively, shrinking one’s investable universe could potentially limit future returns. However, researchers from the University of Oxford and Arabesque Partners aggregated the results of 200 studies globally to report on the impact of sustainability on corporate performance and found the following:

• 90% of the studies conducted showed that sound sustainability standards can lower a company’s cost of capital, allowing these companies to grow with lower costs and to generate potentially greater shareholder returns.

• 88% of the research showed that solid ESG practices resulted in better operational performance.

• 80% of the studies showed that good ESG practices positively influenced a company’s stock price.

In other words, investors should not think of sustainable investing as shrinking the investment universe, but rather focusing on companies within that universe that may provide the best prospects.

As investors continue to seek out sustainable investments, they are actively encouraging companies to improve their ESG scores. Thus, investing in these types of companies may result in better corporate governance, greater regulatory compliance and other positives, allowing the benefits of a sustainable portfolio to be selfperpetuating. One proxy commonly used to measure the performance of sustainable companies is the MSCI KLD 400 Social Index. This index is comprised of firms in the U.S. with the highest ESG factor ratings relative to their industry peers, and it completely excludes companies in the alcohol, gambling, tobacco, weapons, and adult entertainment industries.

Over the past 10 years, the MSCI KLD 400 Social Index has slightly outperformed the S&P 500 Index and has also done so with slightly lower volatility. This shows that, historically, investing sustainably has generated market-like returns. And, by investing selectively, sustainable investors can make their voices heard about what they want in their investments.

Yet many challenges remain before sustainable investing is truly open to any investor. One of the biggest is that there isn’t yet one agreed upon definition of what makes an investment “sustainable.” A recent ruling by the U.S. Labor Department, which cleared the way for managers of pension funds and 401(k) plans to consider ESG factors in their investment decisions, was a watershed moment for sustainable investing. However, the ruling didn’t consolidate the different definitions that portfolio managers have for “sustainable.” Fortunately, the amount and availability of ESG data does means investors can judge companies individually, rather than having to eliminate whole sectors based on their values.

Clearwater Capital believes analyzing a company’s ESG factors as an integral part of traditional financial analysis can add value to investors’ portfolios. As more information and investment vehicles become available, we anticipate that these ideas may become even more widely accepted, perhaps to the point where they are standard considerations for most investment managers, making it much easier for us to implement portfolio strategies that reflect our client’s values. Thank you for your continued trust and confidence. Please feel free to contact me directly to discuss these observations in greater detail. James Chapman, June 2017