ESG investing is an investment strategy that combines material environmental, social, and governance (ESG) factors with traditional financial information. These factors represent risks and opportunities that may have financial effects on a company’s performance but may not be reflected in the usual market data. An investor using an ESG strategy seeks to improve stock selection by expanding the information considered while investing in a sustainable and responsible manner.
Board members may wonder whether the institution’s investment policy can or should include a direction to engage in ESG investing. Some board members may be interested in ESG investing as a way to improve returns on a risk-adjusted basis, some as a more appropriate way to respond to calls for divestment of oil and gas stocks, others as a way to align the institution’s investment strategy with its mission, and still others may want to focus the investment strategy on long-term benefits.
Board members re-examining an institution’s investment policy should consider their fiduciary duties of loyalty (to act in the institution’s best interests and not for the benefit of someone or something else) and of care or prudence (to care for and manage the institution’s assets). A board member should act as a prudent investor with respect to the institution’s investment assets, taking into consideration general economic conditions, the college or university’s long-term and short-term needs for the assets, and the university’s purposes.
In the past, fiduciaries were cautioned against engaging in “socially responsible investing” (SRI) because of an assumption that it would result in a financial cost to the portfolio. Early SRI used negative screens, and modern portfolio theory, with its emphasis on diversification, assumed a cost if a negative screen caused a sector to be removed from a portfolio. In recent years, numerous financial studies, including several meta-studies, have provided performance data comparing SRI funds with non-SRI funds (funds unconstrained by SRI factors). Studies have found that SRI funds have performed as well as or better than non-SRI funds. ESG investing has been found to be more likely to result in better-than-benchmark returns than screening strategies. Studies have also shown that companies with high ratings in corporate social responsibility and ESG factors have a lower cost of capital than companies with lower ratings.
The prudent investor standard serves as the primary fiduciary guide for investment decision making. It evolved from a conservative, risk-averse standard in the 19th century to a standard that embraced modern portfolio theory in the mid-20th century. Now in the 21st century, with data that show that ESG investing does not necessitate a cost to the portfolio, the prudent investor standard has evolved to encompass ESG investing.
Actual performance of a portfolio depends on a variety of factors, including the skill of the manager and economic conditions that favor one sector of the market during a particular time period. Although ESG investing may improve a fund’s performance, and evidence of improved performance through the use of ESG factors exists, a determination that ESG investing will improve returns is not necessary for ESG investing to be considered within the scope of what a prudent investor can do. Many analysts in the financial sector already use ESG factors as part of their process, and because prudence is in some respects an industry norm, it is useful to know that the sector now gives ESG investing serious consideration.
A board member managing a college or university endowment must act as a prudent investor, and prudent investors can consider adopting an investment strategy that takes into account material ESG factors as well as traditional financial metrics. Indeed, given a recent Supreme Court decision—Tibble v. Edison International, that holds that fiduciaries have an ongoing duty to monitor investments—fiduciaries should review their investment policies and consider whether changes are appropriate.
Attend the Responsible Investing Roundtable at AGB’s Foundation Leadership Forum, January 24-26, 2016, in Los Angeles. www.agb.org/Forum.