Managers—and, by extension, plan sponsors—must ensure that socially responsible investments get proper due diligence before they are included or excluded from portfolios.

The growth of socially responsible investing (SRI) has brought increased product proliferation to the market, complicating the landscape of socially responsible investments. Currently, screening out certain market segments, such as alcohol or tobacco, is an accepted method of constructing an SRI portfolio. Some investment managers may focus on only one factor—environmental initiatives, for example—while others may exclude multiple areas of the market. However, excluding investments based solely on screens may result in missed alpha opportunities and limit diversification. In order to maximize alpha in SRI, it’s critical to balance fundamental research with negative and positive screens.

Screen Wisely

SRI portfolios comprise companies that implement environmental, social and governance (ESG) factors. Each of these components matters, but they need to be considered as a whole. Companies that may seem weak in one ESG area could turn out to be very strong in another and may also have the resources to enact change. For example, an energy company that would normally be excluded based on a negative environmental screen may have several strong social policies in place. It may work well with its community or bring economic stability to its region, making it an attractive socially responsible investment.

While screening for ESG factors is an important first step for many managers, it’s critical to examine each segment of the market appropriately. For example, insurance and utility companies should not be held to the same ESG criteria since their business models are vastly different. However, it is important to establish general standards against which companies can be measured, such as a set of governance criteria. It’s also important to communicate with organizations that may not initially meet the portfolio’s ESG mandate.

Research Carefully

Integrating ESG factors with fundamental research practices, such as in-depth analysis of balance sheets and cash flow statements, helps highlight the best investment opportunities. For astute managers and analysts, a fundamental research base is critical to understanding the intricacies of each investment. For example, a pharmaceutical company with strong ESG characteristics may not be a sound investment based on these merits alone. However, analyzing the company’s financials could uncover cost efficiencies, and then the investment could be fully evaluated.

Also, through ongoing dialogue with management teams and proxy voting, investors are able to monitor the organizations in their portfolios to ensure that the SRI criteria are being followed. Since management meetings and proxy evaluation are already standard responsibilities within a fundamental research platform, layering on the ESG elements will add new depth to the analysis. As interest in SRI grows, companies will become more attuned to corporate responsibility.

ESG Benefits

Often, a company’s sensitivity to social responsibility is an indication of a sharp management team and a solid franchise. For example, employing social standards, such as emphasizing worker safety, can increase productivity. Similarly, strong corporate governance policies, such as implementing an independent board of directors, can increase shareholder trust, which correlates positively to a company’s value. As SRI grows, ESG principles will become more prominent in conventional business practices, which will benefit companies and investors alike.

The worlds of SRI and conventional investing are becoming more aligned. However, since ESG factors are not absolutely defined, it can be difficult to navigate this developing space. Through the integration of ESG factors into fundamental research, investors can achieve a research-based portfolio that meets both SRI considerations and performance goals.

Eileen Rominger is the co-chief investment officer for the U.S. value equity and global equity teams, and Dolores Bamford is a portfolio manager for the U.S. value equity team. Both are with Goldman Sachs Asset Management. gsam-value-team@gs.com

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the November 2008 edition of BENEFITS CANADA magazine.

 

Copyright © 2018 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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