What is ESG investing?

Sustainability and ESG (environmental, social, and governance) factors are increasingly front of mind for many Canadian investors. With governments and policymakers increasingly introducing new regulations around ESG issues, companies and portfolio managers have had to adapt accordingly. This cultural shift has taken place rapidly, however, leaving many investors playing catch-up. In this article, we’ll explain what ESG investing is and what it means for investors.

Understanding ESG investing

ESG investing is generally defined as any strategy that incorporates one or more environmental, social and governance factors in investment decisions and active ownership. While it can take many forms and may go under different names, including sustainable investing and socially responsible investing,  these approaches all assume that the health of our natural environment, the strength of the social infrastructure in our communities, and the way companies are managed all play vital roles in creating value. Therefore, incorporating ESG risk analysis into research is an important tool to understand the true value of an investment, mitigating risk, and identifying new opportunities.

What ESG stands for: factors that may be relevant to investors

Let’s take a closer look at the three factors that make up ESG and how they might impact investment decisions:

  • Environmental factors consider how a company’s operations impact the natural environment (such as water contamination) and how the environment impacts the company (for example, water scarcity).

As recognition of environmental risks such as climate change, loss of biodiversity, and other threats grow, society is increasingly penalizing polluters through taxes or regulatory change.

Companies with improving or better ESG performance will therefore be seen as having more sustainable business models. New products and services that can accelerate the transition to a cleaner, low-carbon economy could unlock significant business opportunities.

  • Social factors have to do with the relationship between a company and its employees, consumers, suppliers, and communities.

Companies face a risk of increased regulation and the alienation of valuable business partners, talent, and other stakeholders through mismanagement of these relationships. On the other hand, companies that best manage their relationships with stakeholders build robust value chains while remaining at the forefront of social change.

  • Governance factors relate to the structures or systems put in place to make sure company management is effective. Issues most relevant to investors include the makeup and oversight of the board of directors, executive compensation, capital management, dividend pay-outs, and mergers and acquisitions.

While firms can incur operational and disclosure-related costs as they engage in good corporate behaviour, they also stand to enjoy efficiency gains, greater trust from stakeholders, reduced firm-level tail risk, and other long-term benefits.

Environmental, social and governance: understanding the three factors of ESG
Graphic showing the components of ESG: Environmental, social, and governance.
     

Environmental

  • Climate change
  • Pollution
  • Natural resource utilization
  • Biodiversity
  • Water scarcity
  • Waste management
  • Other environmental issues

Social

  • Health and safety
  • Labor relations
  • Diversity
  • Human rights
  • Respect for the community
  • Other stakeholder expectations

Governance

  • Board composition and oversight
  • Executive compensation: structure, performance metrics, and oversight
  • Minority shareholder rights protection
  • Capital management, dividend payouts, and dilution
  • Corporate actions (e.g., M&A) and corporate strategy

 

Why is ESG important for investors?

Depending on the specific strategy, ESG investing can aim to align the portfolio with a set of ethical or personal values, and generate measurable social and environmental outcomes. Moreover, sustainable investing can offer investors an information advantage by enabling them to assess the long-term viability of a company’s business model if faced with future ESG shocks, be they internally-created (such as labour stoppages, polluting incidents, or water scarcity) or externally-created (such as regulatory changes or changes in investor preferences). By looking at a company’s ESG incident track record, investors can find valuable information that could flag issues, including vulnerabilities in corporate strategy, inadequate governance structures, or poor decision making—which may impact share price.

What are the benefits and drawbacks of ESG investing?

The most obvious benefit of ESG investing is that it helps align your personal values and beliefs to your financial portfolio, which can help you feel more attached to your portfolio in the long-run. From a financial point of view, evidence suggests that companies with better ESG records generally have better financial performance than those with worse ESG records, and also that portfolios that integrate ESG analysis into the investment decision-making process have outperformed those that don’t. Investing with an ESG mindset could also put you ahead of the game as regulators increasingly demand that companies disclose ESG risks, putting a premium on those companies that are already doing just that.

There are also potential drawbacks of ESG investing to consider. For example, sustainable investing might mean divesting from certain industries such as oil, so if those sectors outperform, portfolio performance could suffer. It’s also important to carefully choose your ESG strategy and fund, as the popularity of ESG investing has unfortunately been accompanied by greenwashing on the part of some corporations and fund managers, making deep analysis of the portfolio’s investment even more critical. This is even more true since there is little standardization of ESG data (that is, ESG data providers have very different methodologies), making comparisons between companies and funds very difficult. 

How is ESG investing carried out?

Just a decade ago, ESG investing was largely confined to excluding investments in companies that produce goods and services perceived as harmful to society. While this approach still has a role to play (see “Negative screening” below), today's portfolio managers are increasingly proactive, directly engaging with firms and investing in those making the most significant positive impact. This can go beyond simply integrating ESG factors into investment decision making to actively encouraging companies to improve their sustainability credentials through ongoing stewardship.

While almost all ESG approaches aim to deliver competitive financial returns by managing ESG risks and identifying ESG-related opportunities, how they do so can differ widely. Some of the most common options available include:

  • ESG integration (including active ownership) involves consideration and analysis of ESG factors as part of the investment decision-making process. It aims to deliver competitive financial returns and identifies ESG risks and opportunities.
  • Stewardship is a process of continually developing best practices throughout the stages of the investment lifecycle, through company engagement, ongoing review by the fund manager, proxy voting, and direct asset operation.
  • Negative screening involves excluding and/or divesting from companies in certain industries,  most commonly the alcohol, tobacco, firearms and weapons, and gambling sectors.  
  • Positive or best-in-class screening targets companies or industries with better-than-average ESG metrics and records.
  • Thematic/sustainability-themed investing specifically targets certain ESG themes such as clean energy, green property, aligned solutions, etc.
  • Impact investing targets investments that can make a social or environmental difference. Impact investing can aim to deliver competitive financial returns or, in certain circumstances, below market rate returns for investors not primarily focused on financial reward. 

 

A broad spectrum: common methods of ESG investing
Graphic showing the spectrum of sustainable approaches, from traditional investing to philanthropy.
Source: Manulife Investment Management, April 2022

Although these options vary in their commitment to ESG principles, they’re not mutually exclusive, and ESG investment strategies may incorporate any number of these approaches.

A maturing ESG landscape

ESG investing has come a long way over the last few decades, and its evolution is ongoing. While it can be difficult keeping up with the latest trends, it’s important to remember the key aims of ESG investing—it can help align a portfolio with a set of values that are important for the investor.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management nor any of our affiliates or representatives (collectively Manulife Investment Management) is providing tax, investment or legal advice.

This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here.  This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social ,and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Manulife Investment Management

Manulife Investment Management is the global brand for the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship and the full resources of our parent company to serve individuals, institutions, and retirement plan members worldwide. Headquartered in Toronto, our leading capabilities in public and private markets are strengthened by an investment footprint that spans 18 geographies. We complement these capabilities by providing access to a network of unaffiliated asset managers from around the world. We’re committed to investing responsibly across our businesses. We develop innovative global frameworks for sustainable investing, collaboratively engage with companies in our securities portfolios, and maintain a high standard of stewardship where we own and operate assets, and we believe in supporting financial well-being through our workplace retirement plans. Today, plan sponsors around the world rely on our retirement plan administration and investment expertise to help their employees plan for, save for, and live a better retirement.

This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions.

Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

552618

Manulife Investment Management

Manulife Investment Management

Read bio