Last Thursday, Pope Francis called upon Catholics to divest themselves of industries engaged in production of armaments and fossil fuels. In his 225-page encyclical letter, the Pope implored the faithful to focus instead in investments that are compatible with promotion of human rights and environmental responsibility. Last month, over 40 faith-based organizations pledged to eliminate fossil fuel investments, and the Vatican Bank confirmed that it held no oil or gas assets.
The idea of shunning certain industries from one’s investment portfolio is nothing new. Avoiding so-called “sin stocks” like alcohol and tobacco has long been important to many investors as a statement of principle. But over the past decade, a more systematic approach to applying social responsibility to investment decision making has gone mainstream and is now ready for prime time.
“ESG”, or Environment, Social and Governance-focused investing was once a relatively tiny corner of the market that offered limited choices with relatively poor returns, and generally targeted a small subset of activist-minded devotees. No longer. Today choices abound and returns are broadly comparable to portfolios that disregard social mandates, and the share of total portfolio allocations to ESG is approaching parity.
Consideration of social principles in finance trace back to antiquity. Prohibitions against usury appear in the Mosaic Law date back at least to the 8th century BCE, in Christian doctrine from the time of Constantine, and Islamic scripture from the early 7th century AD. In America, Methodists of the 1700s were exhorted to avoid investing in promotion of alcohol, weapons, tobacco and gambling. Other religious denominations often practiced similar exemptions.
The rise of social activism related to racial tensions and the Vietnam War of the 60’s and 70’s spawned greater focus on methodical adoption of socially responsible investment principles. In particular, widespread divestment of investments in South Africa helped push the teetering practice of Apartheid over the edge, culminating with the ultimate election of Nelson Mandela in 1994.
But the movement struggled to take root more broadly, given the difficulty of excluding certain sectors from a portfolio of broadly diversified funds, and the lackluster performance of the handful of targeted ESG investments. Today, the momentum has shifted and the menu of socially responsible options is much broader. In addition, corporations have moved significantly in the direction of transparency in corporate governance and environmental sensitivity. There is much more work to do, but investors are no longer confronted with a stark tradeoff between expressing their priorities and earning an acceptable return.
As of 2018, over 80% of the world’s largest corporations report their social and environmental practices according to a set of global standards called the Global Reporting Initiative, information that is increasingly demanded by potential investors. And guess what? It turns out that according to numerous studies, companies that observe responsible ESG policies on average produce better financial results with lower volatility. Even some of the biggest energy companies like Exxon Mobil have recognized the threat to their business models and the broader economy posed by climate change and have made strides in enhancing transparency and seeking less carbon-intensive diversification alternatives.
Today about $20 billion or one fourth of all professionally managed assets are subject to ESG mandates. A broadening collection of funds offer ESG options to individual investors as well, while companies in general are increasingly prioritizing socially responsible policies without sacrificing performance. A 2019 study conducted by the IMF estimates that over 1,500 funds are subject to explicit ESG mandates and that their performance is statistically to equivalent or better than agnostically-managed funds.
It’s possible to have your cake and mind your carbon footprint too.
Christopher A. Hopkins, CFA