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Sustainable Investing

Sustainable Investing

| April 26, 2021
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ALIGNING WITH SUSTAINABLE INVESTING

On April 22, the world will mark the 51st Earth Day. This year’s theme will be Restore Our Earth. It represents a chance to learn about the environmental challenges we face today, ways to become more involved, and ways to align one’s personal choices in order to make a positive impact.

Many of today’s headlines—numerous severe weather events, continued deforestation, and increased concern with plastic pollution—are part of key environmental megatrends: climate change, natural resource scarcity, and pollution. Investors keeping an eye on these headlines are increasingly aware of an investment mandate that approaches these megatrends through a different lens. Not only does sustainable investing help fortify returns with its unique focus on risk management, it also aligns an investor with investee companies seeking to improve their environmental, social, and governance (ESG) impacts. These environmental megatrends require one to consider how their personal choices can positively impact these challenges. Increasingly, sustainable investment portfolios can provide increased transparency, align with investee companies that publicly disclose their efforts to improve their ESG impacts, and utilize asset managers that fulfill a stewardship role by holding investee companies accountable to improve their ESG impacts.

FRAMING TODAY’S ENVIRONMENTAL CHALLENGES
Today’s environmental challenges are substantial. According to the Intergovernmental Panel on Climate Change, the impact of 1.5°C of warming would disproportionately affect disadvantaged and vulnerable populations through food insecurity, higher food prices, income losses, lost livelihood opportunities, adverse health impacts, and population displacements. It is estimated that the global economic damages of climate change for increases of 1.5°C or 2°C will be $54 and $69 trillion, respectively.1 Unsustainable pressures on natural resources, including population growth, longer life expectancy, economic growth, and increased consumption in developed and emerging countries, threaten continued degradation of nature. According to The Lancet, pollution is the largest environmental cause of disease and premature death in the world today.2


The transition to a low-carbon, more sustainable, and cleaner economy entails both risks and opportunities to business activities. The risks to high-emission businesses are more obvious. However, the risk from supply, operational, and resource management issues are more complicated and will require increased transparency. For example, companies are increasingly expected to understand, manage, and disclose their supply chain risks (i.e., carbon emissions, resource sourcing and usage, waste, employee treatment). Failure to do so will lead to operational, reputational, and financial risks, including stock price performance.

OVERVIEW OF SUSTAINABLE INVESTING: A WAY TO MAKE AN INVESTMENT IMPACT
Responsible investing, or sustainable investing, is the explicit inclusion of ESG risks and opportunities in investment analysis. This investment approach allows for increased:
• Awareness of what’s in a portfolio, through the process of ESG Investing,
• Alignment with what matters to the investor, through the use of screens and ESG integration, and
• Accountability on the part of the asset manager to act as a steward of the investor’s assets, through active engagement with the investee company.
As shown in [Figure 1], sustainable investing mutual funds and exchange-traded funds (ETFs) continue to attract record flows from investors.

AWARENESS
ESG investing intentionally assesses the implications of environmental risks and opportunities on each investee company in a portfolio. Many asset managers explicitly seek to integrate ESG factors into the investment process to understand and lower investment risk.3 For example, an asset manager may have a research process that systematically requires the evaluation of company data on issues such as emissions, energy management, waste management, customer welfare, labor relations, materials sourcing, and supply chain management. If an asset manager is considering to add a food manufacturing company to their portfolio, they can use this data to create a scorecard and identify those food manufacturing companies that score best on these issues.

ALIGNMENT
Asset managers can utilize increased awareness from ESG investing to decide whether to avoid, reduce, or increase exposure to an investee company. This process helps an investor align with an improvement story—investee companies that are intentionally striving to improve their environmental impact. For example, to limit carbon exposure in a portfolio, an asset manager may avoid all carbon extracting companies (i.e., oil or coal), or, using the scorecard approach, the asset manager may only include those companies that have the best environmental scores, which is known as a “best-in-class” approach.


ACCOUNTABILITY
Asset managers can act as stewards by engaging with an investee company to help address environmental relative risks. Through engagement dynamics of building relationships, enhancing knowledge, and exchanging information, this stewardship role helps hold investee companies accountable to improve their environmental impact. Returning to the scorecard example above, the asset manager identifies a food manufacturer that scores poorly on its supply chain management relative to its competitors due to its relatively high emissions and poor resources utilization. The asset manager could then engage with the company and work to get commitments from company management to reduce its emissions and seek more sustainable resource utilization in its supply chain.

Read the Guide To Sustainable Investing.

1 Intergovernmental Panel on Climate Change. 2018. https://www.ipcc.ch/sr15/chapter/spm/
2 The Lancet. 2017. https://www.thelancet.com/journals/lancet/article/PIIS0140-6736(17)32345-0/fulltext
3 CFA Institute. 2017. https://www.cfainstitute.org/en/research/survey-reports/esg-survey-2017
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
An Environmental, Social and Governance (ESG) fund’s policy could cause it to perform differently compared to funds that do not have such a policy. The application of social and environmental standards may affect a fund’s exposure to certain issuers, industries, sectors, and factors that may impact relative financial performance — positively or negatively — depending on whether such investments are in or out of favor.
US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.
All index data from FactSet.
Please read the full Outlook 2021: Powering Forward publication for additional description and disclosure.
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