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Institutional and retail investors are increasingly interested in environmental, social and governance (ESG) investing. The increased corporate transparency of an ESG framework is attractive to many investors, but navigating how to properly apply these considerations effectively to portfolios can be difficult.

In this article, Fisher Investments Canada will help you better understand ESG investing and explain how you can incorporate it into your investment strategy. We will also discuss the various risks and shortfalls ESG factors can pose and how these may impact your investments.

What is ESG investing and why does it matter?

Environmental, social and governance factors represent an opportunity to invest while rewarding positive corporate behaviour. Here are some examples of items investors can consider within each category:

  • Environmental – How a company uses resources and energy, manages waste and emissions and plans for climate change.
  • Social – How a company treats its workforce, approaches health and safety issues and relates to the communities in which it does business.
  • Governance – A company’s diversity, business ethics, employee-compensation practices, board independence and ownership structure.

These factors have always been important to understand alongside financial and other fundamental factors whilst assessing risk in equities. However, the rising interest in ESG investing has improved corporate transparency to help investors gauge the progress – or lack thereof – companies are making in these areas.

How do you pick the right ESG strategy for you?

ESG strategies can vary widely, making it difficult for investors to understand how different frameworks can impact their portfolios. One common strategy is an “exclusionary approach”, where investors eliminate equities or categories with less-desirable ESG characteristics. A common example is excluding a combination of alcohol, tobacco, gaming or weapons-production companies.

Another approach focuses on investing in companies that can enact environmental or societal change. These can range from companies tied to renewable energy and electric vehicles, to leaders in diversity initiatives. Others blend multiple approaches. Take some time to consider what approach – or blend of approaches – works best for you and your ESG goals.

How do you incorporate ESG factors into your investment strategy?

Fisher Investments Canada believes thorough investors should carefully consider the materiality of ESG risks regardless of how (or if) an ESG framework is applied to your portfolio. Investors can apply ESG elements to portfolios in different ways. We recommend employing a top-down investment process to consider ESG-related opportunities and risks throughout the portfolio-management process. We believe it helps to start at a high level and incorporate ESG factors like environmental regulation, social policy, economic and market reforms, etc., when developing a macroeconomic forecast and thematic preferences.

From there, you can more easily identify companies that are a good strategic fit and apply nuanced ESG considerations. For example, investing in mining companies can carry unique risks that make it critical to understand corporate policies around mine safety. Another example may be looking out for concentrated ownership structures. Large equity owners can have more influence on a company’s strategy. They also can affect the equity price if they decide to change their holdings materially. These company-specific ESG risks shouldn’t necessarily keep you from purchasing shares, but they are worth understanding and monitoring.

What are some of the limitations to ESG investing?

Varying industry-rating guidelines can make it difficult to assess and compare ESG strategies. ESG rating companies have developed their own approach for quantitatively measuring ESG factors – a difficult task, given many components are qualitative in nature. Rating firms evaluate a wide scope of factors to come to an ESG “score”. However, this score is inherently subjective since it depends on the criteria the raters choose to emphasise.

Rating firms often give wildly different scores for the same companies. For example, when it comes to numerically assigning a “social” score – ranging from a corporation’s leadership diversity to its child- or slave-labour exposure – raters emphasise variables differently, which can impact the broader score. Even when an issue is theoretically possible to measure, like carbon-emissions output, there are data limitations that make calculations more art than science. Raters can only estimate these figures and estimates tend to range widely.

These obvious shortfalls don’t mean you should ditch ratings altogether, but they do necessitate awareness and due diligence. Understanding ratings methodology should help inform whether you agree with their conclusions. Awareness of risks, whether ESG-related or not, is part of making a sound investment.

Does ESG investing add value to total returns?

Though ESG investing is becoming a more popular preference for some investors, it is difficult to quantify whether adhering to ESG-related restrictions materially impacts returns. The market has no standard ESG definition and since approaches can vary widely, there is no great way to measure performance differences.

Some areas of the market are more ESG-friendly than others. For example, companies in the technology sector often appear attractive from an ESG perspective given their exposure to efficiency gains, underlying technology supporting renewables and small production footprints. Conversely, energy companies tend to be resource-intensive and often don’t rank highly for ESG factors. Consider how a portfolio that restricts all energy companies may perform when compared to a portfolio with no restrictions. The relative performance of the portfolio with restrictions will suffer if energy firms perform well and will benefit if energy does poorly. Another example is that developed markets tend to have more favourable ESG characteristics than emerging markets. Emerging market companies tend to have less-diverse boards, higher ownership concentration and less technology exposure. Thus, the gap between developed and emerging market performance can similarly impact relative performance.

ESG investing is only one of many factors investors can assess to meet their financial goals, and it isn’t inherently a superior approach. If you decide to venture into the ESG realm, Fisher Investments Canada thinks it best to integrate it into a comprehensive investment process to achieve your ESG objectives and long-term financial goals.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

Fisher Investments Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.

This content was produced by Fisher Investments Canada. The Globe and Mail was not involved in its creation.