10.3 Ethical Investing and Socially Responsible Investing (SRI)
6 min read•august 15, 2024
Ethical investing and socially responsible investing (SRI) are game-changers in finance. They let you put your money where your values are, supporting companies that do good while avoiding those that don't. It's not just about profits anymore – it's about making a positive impact.
These approaches are reshaping how businesses operate. By considering environmental, social, and governance factors, investors are pushing companies to be more responsible. It's a win-win: you can potentially earn returns while driving positive change in the world.
Ethical and Socially Responsible Investing
Principles and Strategies
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Why the World Needs Both ESG and Impact Investing | Bridgespan View original
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What Is Impact Investing and Why Should You Care? | Bridgespan View original
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Ethical investing focuses on aligning investments with moral principles and values, avoiding companies engaged in activities deemed unethical (weapons, tobacco, gambling, environmental damage)
Socially responsible investing (SRI) incorporates environmental, social, and governance (ESG) factors into investment analysis and portfolio construction alongside traditional financial metrics
strategies exclude companies or industries that do not meet specific ESG criteria
strategies actively select companies with strong ESG performance
targets investments in companies, organizations, or funds with the intention of generating measurable social and environmental impact alongside a financial return
involves using shareholder voting rights and engagement to influence corporate behavior and policies related to ESG issues
directs capital to underserved communities to support economic development, affordable housing, healthcare, education and other social causes
Benefits and Objectives
Aligns investments with personal values and ethics, allowing investors to put their money towards companies and causes they believe in
Promotes corporate social responsibility by rewarding companies with strong ESG practices and encouraging others to improve their ESG performance to attract investment
Drives positive social and environmental change by directing capital towards sustainable and impactful businesses and projects
Mitigates ESG risks and identifies long-term investment opportunities by incorporating material ESG factors into financial analysis
Satisfies growing investor demand for responsible investment options and helps mainstream the consideration of ESG issues in the investment industry
Factors in SRI Decision-Making
Environmental Factors
Assess a company's impact on and stewardship of the natural environment
Consider issues such as carbon emissions, energy efficiency, waste management, water usage, pollution prevention, and conservation efforts
Evaluate environmental policies, management systems, and performance relative to industry peers
Analyze potential risks related to climate change, resource scarcity, and regulatory changes
Social Factors
Evaluate a company's relationships with stakeholders, including employees, customers, suppliers, and local communities
Examine issues such as labor rights and working conditions, diversity and inclusion, human rights, product safety and liability, data privacy and security
Assess social policies, practices, and performance in areas like employee engagement, customer satisfaction, supply chain management, and community relations
Consider potential risks and opportunities related to changing consumer preferences, demographic shifts, and social movements
Governance Factors
Examine issues related to corporate oversight, accountability, and alignment with shareholder interests
Analyze board composition and independence, executive compensation, shareholder rights, political contributions and lobbying, and anti-corruption policies
Assess the quality of corporate governance practices, transparency, and risk management systems
Consider potential risks related to management misconduct, regulatory violations, and reputational damage
Materiality and Analysis
Materiality considers which ESG factors are most relevant and impactful to a company's financial performance and long-term value creation within its specific industry
Qualitative and quantitative analysis is applied to assess a company's ESG risks, opportunities, and performance relative to industry peers
ESG analysis may include reviewing corporate disclosures, engaging with management, conducting site visits, and consulting with stakeholders
Ratings and rankings from ESG research providers (MSCI, Sustainalytics) and third-party organizations help inform SRI decision-making, though methodologies vary
SRI vs Traditional Investment Performance
Financial Returns
Studies show mixed results regarding the financial performance of SRI funds compared to traditional funds, with some indicating outperformance, similar returns, or slight underperformance
Meta-analyses suggest there is no systematic performance penalty associated with SRI funds, and they provide competitive risk-adjusted returns over the long-term
Morningstar research found that outperformed traditional peers in 2020 during the COVID-19 market downturn, demonstrating resilience
A 2015 Deutsche Asset & Wealth Management and Hamburg University study found that incorporating ESG factors into investment processes had a positive effect on corporate financial performance in 62.6% of meta-analyses examined
Performance Drivers and Variability
SRI fund performance can vary based on asset class, investment style, screening intensity, and market conditions
Exclusionary screening may limit diversification and potentially lower risk-adjusted returns, while best-in-class and ESG integration approaches show more positive results
SRI funds focused on small and mid-cap companies, emerging markets, or thematic investments (clean energy, gender diversity) tend to outperform
Incorporating material ESG factors into investment analysis can help identify risks and opportunities often overlooked by traditional financial metrics, potentially enhancing long-term performance
Increased investor demand and capital flows into SRI funds may contribute to their strong performance in recent years as ESG investing moves towards the mainstream
Risk Management and Long-Term Perspective
Companies with strong ESG practices may exhibit lower risk and volatility over time due to better management of environmental and social risks, regulatory compliance, and reputational issues
ESG analysis can provide a more comprehensive assessment of a company's long-term financial prospects and help identify potential red flags or hidden opportunities
Sustainable companies may be better positioned for the transition to a low-carbon economy and more resilient to systemic risks like climate change and resource scarcity
Integrating ESG factors can help create more stable, long-term investment portfolios aligned with the extended time horizons of many institutional investors (pension funds, endowments)
SRI Impact on Corporate Social Responsibility
Capital Allocation and Valuation
SRI helps drive by rewarding companies with strong ESG practices and performance through capital allocation and higher valuations
Companies with high ESG ratings often trade at premium valuations and have lower costs of capital, incentivizing others to improve their sustainability efforts to attract investment
Negative screening and divestment campaigns create pressure for companies to address ESG concerns and transition away from harmful activities to maintain access to capital
Positive screening and best-in-class approaches direct more capital to sustainability leaders and encourage industry laggards to adopt better practices to remain competitive
Engagement and Activism
Shareholder activism through , resolutions, and direct engagement pushes companies to enhance disclosure, set ambitious sustainability targets, and implement ESG-related reforms
Investors can file shareholder proposals on issues like climate change, diversity, and political spending to prompt corporate action and transparency
Collaborative investor initiatives (Climate Action 100+) engage with high-emitting companies to curb emissions, strengthen climate governance, and align with Paris Agreement goals
Investor demands have led to increased ESG reporting, board diversity, and linkage of executive compensation to sustainability performance at many companies
Partnerships and Industry Initiatives
SRI partnerships with NGOs, academia, and other stakeholders help develop ESG standards, metrics, and best practices that raise the bar for corporate sustainability
Collaborations like the United Nations and Ceres mobilize global investors to advocate for policy changes and collective action on ESG issues
Investor-led organizations promote the integration of ESG factors into investment practices and support research and education on sustainable finance (US SIF, GIIN)
Industry initiatives provide frameworks and guidance for companies to improve ESG disclosure and performance (GRI, SASB, TCFD)
Mainstreaming Sustainability
The growth of SRI into the mainstream investment community signals that sustainability is increasingly seen as a core business issue and driver of long-term financial success
Rising demand for ESG investing options from institutional and retail investors alike puts pressure on companies to prioritize sustainability and responsibility
Governments and regulators are also focusing on ESG issues, with mandatory reporting requirements, carbon pricing, and green finance policies accelerating corporate action
Corporate leaders recognize the importance of sustainability for competitiveness, risk management, and value creation, leading to more proactive ESG strategies and investments