Portfolio and Governance Impact: Divestment, SRI, & ESG

Ryan Murphy | Vice President
Zach Heath | Analyst

Divestment, socially responsible investing (SRI), and environmental, social, and governance (ESG) are all buzzwords in today’s investment environment. More so than ever, investors are striving not only to generate financial gains, but to impart positive social impact with their invested capital. In 2019 alone, ESG-oriented investment funds welcomed over $20 billion in net inflows, more than four times that of any prior year.

How are these investment terms ordinarily defined?

Divestment: The reduction or elimination of some kind of asset for financial, ethical or political objectives (excluding violators).

SRI: Avoiding industries that negatively affect the environment and its people. This includes companies that produce or invest in alcohol, tobacco, gambling and weapons (excluding violators).

ESG: The notion that environmental, social and governance (ESG) issues, such as climate change and human rights, can affect the performance of investment portfolios and should therefore be considered alongside more traditional financial factors (including promoters).

Despite the increasing popularity of divestment, SRI, and ESG strategies, investors are discovering that it is easier to ‘talk-the-talk’ than it is to ‘walk-the-walk’ when implementing these mandates. Considerations of the following are paramount to successfully implementing a divestment, SRI, or ESG mandate: (1) Policy: how do you define and formalize divestment, SRI, or ESG? (2) Investment Selection: are there viable investment options available? (3) Portfolio Monitoring: how will you ensure there are no investment violations with the approved mandate? (4) Fiduciary Implications: does your mission/organization require divestment, SRI, or ESG? Understanding the demands of divestment, SRI, and ESG investing can help drive better investor outcomes.

Policy

It is imperative that a committee or board successfully defines and formalizes divestment, SRI, or ESG, prior to implementation. Ask any two investors to define SRI or ESG, and their responses will likely differ. Formalizing the board’s or committee’s own definition of divestment, SRI, or ESG, helps maintain consensus and conviction through market cycles.

Investment Selection

Investment selection is a hurdle when implementing a divestment, SRI, or ESG mandate. Identifying skilled and trustworthy investment managers in this space is difficult for several reasons: (1) Since specialized portfolios are more difficult to manage, investment expenses and minimums are typically greater. (2) Managers must report all accounts as part of their advertised composite performance numbers, nd managing accounts with restrictions may generate unwanted dispersion (3) Investors must determine if divestment, SRI, or ESG strategies are genuine, or if they are a ploy by struggling firms to garner assets. As the number of divestment, SRI, and ESG investment options grows, investment selection becomes increasingly challenging.

Investment Monitoring

Fiduciaries are ultimately responsible for monitoring divestment, SRI, and ESG investments. To help entities conduct diligence and monitor portfolios, screening services are available, but for an additional fee. In addition to tracking investment performance, fiduciaries must monitor the managers’ compliance with the stated ESG, SRI and divestment investment mandates. Implementation of divestment, SRI, and ESG strategies can increase tracking error (i.e. performance dispersion against a benchmark). For example, ESG portfolios are often underweight stocks in the energy sector relative to a standard market index. For better or worse, sector biases, like an energy underweight, can influence relative performance. Understanding portfolio positioning and its impact on performance can help investment committees maintain resolve during periods of relative underperformance.

Fiduciary Implications

Before implementing a divestment, SRI, or ESG mandate, fiduciaries should question whether the mandate aligns with their entity’s mission and/or values. If the answer is no, the best approach may be not to implement portfolio screening. Without alignment of mandate and mission, fiduciaries may fail to maintain conviction during volatile markets, especially if underperformance stems from divestment, SRI, or ESG considerations. In addition, new board or committee members might advocate for additional portfolio screening to reflect their personal values. The result could be additional work for investment committees and the challenges of conflicting opinions among the decision-makers.

When the investment mandate does align with an entity’s mission, fiduciaries may be best able to promote the acceptance and implementation of these strategies. Examples include religious organizations excluding the stocks of companies in conflict with their moral or ethical values, or an organization such as Mothers Against Drunk Driving excluding alcohol stocks from their investment portfolio. At the same time, these investment committees would need to weigh the additional complexities and costs of a screened portfolio, as well as the institution’s commitment to stay with the screening disciplines during periods of relative underperformance. Fiduciary responsibility is centered on process, not outcomes. Through documentation and adherence to sound investment processes, boards and committees can fulfill their fiduciary obligations.

Often the most difficult decisions in life produce the most rewarding outcomes. If the core of an entity’s mission embraces specific exclusions or inclusions, then divestment, SRI, or ESG would be prudent to consider. Mission-driven organizations may be best equipped to face the demands associated with customized investment mandates. When implemented properly, these mandates can produce gratifying outcomes for organizations, while affecting positive changes in society, a true win-win.