With responsible investing now accounting for more than half of assets under management in Canada, financial advisors need to be mindful of what investments can truly be defined as responsible. But to do that, they need to be aware that there are at least two investment approaches aggregated under the big tent definition of responsible investment – and they don’t always align.
The United Nations-backed Principles for Responsible Investment (PRI) guide investment professionals on the first approach: the integration of environmental, social and governance (ESG) factors into the analysis and selection of securities as well as consideration of those same factors when engaging with a company’s management or in proxy voting. The PRI’s approach doesn’t include the morals-based or ethical screening of securities that underpins the second, more traditional approach: socially responsible investing (SRI).
While the investment community is aligned increasingly with the PRI’s amoral, analytical methodology, the investing public remains more accustomed to judging how responsible their portfolios truly are based on the screened investments they hold.
These two approaches can overlap and be synergistic, but they can also be mutually exclusive and even act in opposition. Despite their common goal of improving ESG outcomes, it’s not surprising that their differences can lead to an appearance of greenwashing – or giving a false impression that an investment is more responsible than it truly is. That could then lead to an unfortunate outcome that muddies the identification of genuine cases of greenwashing.
The differences between these two big tent responsible investment approaches can be traced to the analytical roots of security analysis (ESG integration) and the behavioural roots of investor psychology (SRI). Advisors who understand that will serve their clients better by ensuring alignment between the responsible investment strategies they choose to use and their clients’ goals.
Let’s consider the differences. An advisor using a bottom-up ESG integration strategy to choose holdings for a client’s portfolio may determine that carbon risk is material to a company, but not reflected in its stock price adequately. The advisors might avoid the stock due to its poor risk/reward trade-off. If many stocks exhibit carbon mispricing, the portfolio might have a decidedly low-carbon tilt. In contrast, an advisor who is putting together a portfolio for an investor concerned about the climate crisis might want to avoid companies with a high-carbon footprint for more moral reasons.
The financial analysis used in the first, analytical approach produces a portfolio similar to the second, behavioural approach. The strategies co-exist nicely. But what would happen if a high-carbon stock became drastically underpriced? The analytical and behavioural approaches wouldn’t line up. The analytical approach would shift to include the undervalued stocks. That would result in a higher-carbon portfolio and a conflict with the behavioural approach; the stock valuations changed, but the personal values didn’t. The different outcomes could lead to accusations of greenwashing from clients.
But is it greenwashing? These two approaches fit under an expansive responsible investment banner, but they use different lenses to view a portfolio’s holdings. How can advisors help reconcile this appearance of greenwashing for clients?
Noted behavioural economist Meir Statman, Glenn Klimek professor of finance at Santa Clara University, explains that the context in which we examine investor behaviour is shifting to a third framework.
The analytical framework presumes that investors are rational and that they would seek out the best risk-adjusted returns for their investments. This rational behaviour assumption was foundational to modern portfolio theory and underpins strategies such as the ESG integration espoused by the PRI and used in the first example above.
Behavioural finance, the second framework, focused on investors’ demonstrably irrational actions, including overconfidence, risk aversion, recency bias and anchoring, among others. To these subconscious behaviours we now add values, morals, or norms – which are explicit rather than subconscious behaviours that steer us away from purely rational actions.
The third framework incorporates both the analytical framework and behavioural finance. Mr. Statman says investors seek to maximize their overall utility, including both financial and non-financial returns. The utility derived from non-financial considerations – for example, values-based screening – will vary among investors, but they are important to all successful strategies.
Thus, according to Mr. Statman’s new framework, once advisors understand their clients’ financial and non-financial goals, they should be clear about how particular investment approaches align with those goals. A poorly articulated investment strategy may produce unexpected results. For example, a strategy using ESG integration may not always align with some investors’ strongly held values, so a strategy that also employs screening may be more appropriate.
Advisors who understand and distinguish the differences among these responsible investment strategies will be able to set their clients up for success in both their financial and non-financial goals. They will also be able to call out genuine cases of greenwashing when they occur.
Ian Robertson is vice-president, director and portfolio manager at Odlum Brown Ltd. in Vancouver. He also serves as chair of the Responsible Investment Association’s board of directors.