ESG and Impact Investing Beyond Screens

Fundamentals should drive decision-making.

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When it comes to environmental, social and governance factors, investors are confronted by an alphabet soup of acronyms that can make it tough to determine which tools to use. But Meg Starr, vice-president at Goldman Sachs Asset Management, says investors need to be clear about their objectives first and foremost and understand they don’t have to sacrifice returns to integrate these factors across the portfolio.

Investors are right to question whether pure screens can deliver the returns they need, says Starr, noting “socially responsible investing and exclusions historically were over-pitched and under-delivered,” leaving plan sponsors skeptical about the ability of these strategies to help them meet their return objectives.

Over the past few years, the spectrum of environmental, social and governance opportunities has opened up to include not just passive exposures through indexes but also across a range of active investments. “There is no case for giving up returns in public markets,” says Starr. “Through ESG integration, investors can do deep fundamental research on the ESG characteristics of companies and determine what is material from a risk or return standpoint.”

Starr says environmental, social and governance factors are already being used across real estate portfolios, where buildings are being retrofitted and made more efficient to add value down the road and command higher rents. However, active management is a critical differentiator across all areas of environmental, social and governance integration.

Starr cites the example of two Indian garment manufacturers an emerging market equity manager recently looked at. Deep analysis helped identify significant differences between the companies that weren’t apparent from just their financial information. While one company had great prospects and solid financials, it had significant human rights abuses in its labour practices that provided it with an unsustainable — and unacceptable — cost advantage. The issue was actually a material investment risk to the company’s long-term sustainability.

Another emerging area is market-rate impact investing, which sees investors putting money directly into profitable businesses that are aligned with impact themes. “Education, for example, is a space that had little innovation and technology. Recent shifts in this market, however, such as increased access to technology in low-income school districts, have helped create strong fundamentals for investing in education-focused technology companies.”

By mixing private equity and impact investing, investors can foster growth in an industry where there’s both need and profitability. Fundamentals should always be used to drive impact investing decisions. In doing so, investors can find value that hasn’t yet been priced into the market, and identify what to avoid. For example, issues pervade some traditionally popular environmental, social and governance themes such as rooftop solar, where consumer financing can be a challenge. Instead, there are different ways to approach these trends, such as solar panels for commercial and industrial buildings.

Starr has a few key takeaways for plan sponsors, including that environmental, social and governance and impact investing approaches shouldn’t be lumped together and integration can have applications in private, not just public, markets.

Investors should also look at environmental, social and governance as a process, rather than an act, and should go beyond labels to understand how fundamental integration may help capture potential alpha opportunities across a wide set of companies.

“ESG and impact investing can be integrated into conventional asset management,” she says, noting for those investors that are willing to change their mindset, market rates of return are achievable — in fact, they should become the norm.

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