Investing your values. Voting with your dollars. Sustainability, impact, values-based, socially conscious, ESG investing.
There are many ways to describe investing with more than just profit in mind. The diversity of terminology is an accurate representation of the number of ways people and institutions approach this kind of investing. These words mean different things to different people and thus they show up differently within the portfolio construction process.
Historically, building a portfolio that was aligned with your values or principles essentially meant starting with a diversified portfolio, and then leaving out groups of companies whose mission, purpose, or practices did not comport with your preferences. For example, if you wanted to support clean energy, you might leave oil companies out of your portfolio. The challenge with this approach is that it naturally left portfolios less diversified, which typically increases risk.
Alternately, investors could construct portfolios using funds that were specifically geared toward their causes. These types of funds were more niche and fewer of them existed. Additionally, the cost of the funds tended to be higher than their unmodified counterparts.
This left investors with three choices: keep your portfolio even if it doesn’t align with your priorities, sacrifice diversification and increase risk, or pay more for your investments.
Presently, the supply of investments offering some degree of attention to ESG factors is far greater than it was even a decade ago. ESG stands for environmental, social, and governance factors that impact how companies operate.
Companies with strong environmental practices prioritize sustainability initiatives, such as reducing carbon emissions, minimizing waste, and adopting renewable energy sources.
Companies committed to social responsibility prioritize fair labor practices, uphold human rights standards throughout their supply chains, and actively engage with local communities. Additionally, diversity at the board and executive levels is increasingly recognized as a vital component of corporate success and resilience.
Strong governance practices involve transparency, accountability, and alignment of interests between shareholders and management. Key indicators of good governance include board independence, executive compensation alignment with performance, and effective risk management systems.
Despite the growing availability of ESG investing, a challenge is the lack of standardized ESG metrics and reporting frameworks, which can make it difficult for investors to compare companies' ESG performance accurately. Moreover, incomplete or inconsistent ESG data from companies complicates investment decisions. Additionally, greenwashing, where companies overstate their ESG credentials, poses a risk to investors.
Given the headwinds, it can feel daunting to successfully build a cost-effective, diversified portfolio while monitoring specific metrics to determine the efficacy of a purposeful investing approach. After researching numerous methods and comparing countless funds, it became clear that the first step to navigating these options is to identify which metric is most important. What is the number one goal, aside from financial growth and security, that is trying to be accomplished with the portfolio? Without this level of clarity, navigating the options becomes a muddy mess.
At Well Spent, the top criterion considered in building a sustainable portfolio is greenhouse gas emissions (GHGs). First, we build a portfolio with an appropriate asset allocation (the split between how much is in stocks versus how much is in bonds and cash), that is globally diversified and low-cost. Only then do we consider sustainability and other criteria.
When evaluating which companies to include or exclude, each company is given a score. The most significant part of that score is based on GHGs. Companies report the metric tons of greenhouse gas emissions they emit in relation to their sales. That data is used to compare companies within sectors to determine which companies are responsibly managing their GHGs. In other words, we take companies who are in similar industries and order them by how many tons of GHG they emit. This creates a hierarchy within each sector of good and bad actors relative to similar companies.
This methodology eliminates some of the pitfalls that often derail diversification. Rather than simply leaving out entire sectors or industries, we maintain an investment in all sectors. Within these sectors, we reward those with good track records by investing more and penalize companies with bad track records by investing less or not investing in them at all.
This framework has allowed for a measurable difference in the tons of GHG emitted from a typical portfolio versus a portfolio with these sustainability criteria applied.
Other factors that affect a company’s score when being considered for inclusion in portfolios are things like a company’s track record on land use and biodiversity, toxic spills, and water management. Additionally, companies whose revenues are highly related to the use of coal, palm oil, factory farming, child labor, cluster munitions, tobacco, and civilian firearms are typically excluded.
No method is perfect and ours is no exception. Depending on portfolio size and makeup, we can offer further customization to portfolios when more specific restrictions are desired. But for most investors who care about mitigating the effects of climate change and prefer not to support companies with undesirable social practices, this methodology can be effective. It emphasizes diversification while keeping costs low and maintains a specific and measurable strategy for including and excluding companies in a portfolio.
Disclosure: Well Spent is not commenting on the performance of any particular investment or portfolio. Nothing here should be construed as a positive or negative recommendation for any investment or investment strategy. All investing decisions should be made based on your individual circumstances.
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