Sustainable investing is a powerful tool to reallocate the money in the world and use it to fight environmental and social issues like climate change, racial and gender inequality and poverty. Sustainable investing, responsible investing, ethical investing, and moral investing all refer to the same thing. Sustainable investing combines the financial profit of traditional investing and the impact element of your charitable donations. It makes the world a better place, and on top of it, you get to profit from it directly. It is a driving force for change in the financial industry and the world.
- Why should you care about sustainable investing?
- Comprehensive map of sustainable investing strategies
- The biggest challenges of sustainable investing
- About FLIT Invest
Why should you care about sustainable investing?
Sustainable investing gives you the power to shape the world positively while also growing your wealth. You can align your investments with your values and generate a direct positive impact for causes you care about and divest from companies or industries against your values. Sustainable investing is a growing trend that is here to stay. According to a recent report by Morgan Stanley, more and more people are turning towards sustainable practices, with 85% showing an interest in sustainable investing.
1. Align your investments with your values
The first thing you can do is take a look at the company you want to invest in and see if you agree with how they operate. Look at how they make decisions. Is their board diverse? Do they pay fair wages or test on animals? By investing in companies and sectors whose values align with yours, like fighting against climate change, promoting racial and gender equality, animal welfare, or many others, you could successfully support a cause you care about at no extra cost.
On the other hand, divesting (selling) the shares of companies you disagree with forces them to change their strategy.
2. Achieve great financial returns
53% of people who invest sustainably primarily do it for the financial returns. Sustainable investing has proven better than traditional investing not only in terms of positive impact generated but also in terms of financial performance. It has historically performed better than traditional investing in one-, three- and five-year investment horizons. Investing with care is not only a charitable act, but you are also likely making more money this way. Better financial performance makes sense – controversial companies often face a backlash resulting in falling share prices. Sectors whose values don’t align with progressive values, such as combating climate change, could also decline over time. Take oil & gas funds, which are some of the worst-performing investments over the past three years.
3. Realize that you are not too small to make an impact
It is a common misconception that you are too small to make an impact. People with a few thousand dollars of savings do not invest because they believe it’s not going to move the needle. Recently, the now famous subreddit, r/wallstreetbets, took a stance against hedge funds by supporting GameStop, a struggling company that short sellers targeted. The Reddit army of small investors managed to turn around the company’s stock price, skyrocketing it into previously unimaginable heights. It became clear that if you care about a cause, you can make an impact, no matter how small your portfolio is. The unity of small investors could change the fate of the company. Learning from this example, you must stand with companies who care to drive change.
4. Recognize that taking no action is also an action
Taking no action is also an action – and in the case of your investments, you pay the price. Investment firms manage the retirement savings of millions of Americans. They have a fiduciary duty to help you and others save for the future. Still, unfortunately, they have no obligation to invest sustainably. As a result, your standard retirement plan is likely full of companies whose values you may disagree with. As an example, you may believe that climate change is an emergency, but this may not reflect in your portfolio. As a result, you can invest in fossil fuel companies without even realizing it. No matter how responsible you are in your everyday life to fight climate change, your retirement plan could still finance the climate crisis. Similarly, you could advocate for racial equality while inadvertently funding companies with openly racist management by owning shares of their stocks.
If you feel that sustainable investing is overwhelming, and you decide to keep your money in your bank account, you are also making an important decision. A group of non-profit organizations recently published a report finding that in the five years since the Paris Agreement on climate change, the world’s 60 biggest banks have financed fossil fuels in the amount of $3.8 trillion. The top 4 fossil fuel financing banks profiting the most from the climate crisis are Wall Street banks. J.P. Morgan Chase leads the pack with $317 billion, followed by Citi with $238 billion, Wells Fargo with $223 billion and Bank of America with $199 billion. Chances are you already have an account with one of these banks, meaning your money kept in your checking or savings account with these banks is used to finance the climate crisis indirectly.
Comprehensive map of sustainable investing strategies
The purpose of traditional investing is to maximize your financial return by taking only as much risk as you feel comfortable. There are no limitations related to sustainability. You look at how much the risk you are taking and the expected future return in exchange. This method is how investors and companies made most financial decisions until recently. Still, today some investors and companies think in these terms when making an investment decision. Take big oil & gas companies, for example; most of them do not care deeply about the environmental impact of their investment decisions as they continue the exploration & production of fossil fuels. Despite the scientifically proven adverse effects on the climate, they continue these business practices to drive their profits.
On the other end of the scale are charity and philanthropy. Let’s say you already have a rainy-day fund and are on track with your savings for your life goals, such as buying an apartment or going on a big trip, but you also want to do good with your money. The obvious solution is to donate to a charity to support a cause you care deeply about. In this case, your primary objective is to make a positive impact without the expectation for financial returns. However, it is important to highlight that you are not preserving your money with charitable donations and philanthropy, and you can’t use them to save for your life goals.
Many people think that there is a trade-off between doing good and making a financial return and that to make money, you have to forget about your values and morals. In reality, there are many options where you can invest in a way that also creates positive social or environmental impact.
Sustainable investing is an investment philosophy that considers environmental, social and governance (ESG) criteria. To put it simply, sustainable investing is everything else which is between traditional investing and charity. Sustainable investing is also often referred to as responsible, ethical, or moral investing. There are three distinct subsets of sustainable investing strategies.
1. Socially responsible investing (SRI)
Socially responsible investing (SRI) avoids harmful investments that do not align with your values. Which means excluding certain companies from your investment portfolio. As a result, SRI is also often referred to as negative screening. For example, you can avoid investing in fossil fuel companies if you want to fight climate change. Alternatively, you can take a stance against gun violence by not investing in gun manufacturers. If you choose this investment philosophy, it guarantees that you are not investing in something that doesn’t align with your values. However, this does not mean that you are promoting the most impactful industries or selecting the best companies in a particular sector. However, it is still a better investment strategy from a sustainability perspective. You can mitigate the environmental, social, or governance risk in your portfolio by avoiding controversial investments. If you want to follow this investment philosophy, you should run a negative screening check on your portfolio to see if your investments align with your values. Various organizations promote this practice, such as the leading shareholder advocacy non-profit in the US, As You Sow. Their tool is called Fossil Free Funds. It allows you to check the environmental impact of your investments in your 401(k), retirement plan, or general investment portfolio.
Investors who solely apply the SRI strategy are often criticized for only using it as a risk management strategy by minimizing their portfolios’ negative impact instead of maximizing the positive impact.
2. ESG (Environmental, Social and Governance) investing
ESG investing is an investment strategy that promotes investing in companies that perform well in any or all of three categories: environmental, social, and governance. For example, it could mean they do not harm the environment with their practices, treat their workers and the communities fairly, and work to achieve gender equality among their leaders. The companies are usually rated according to many factors and receive a final ESG score based on their performance across all three categories.
ESG investing has three different investment approaches:
- Positive screening (or often referred to as best-in-class screening): Applying positive screening means that you are selecting best-in-class companies in a specific sector and avoiding companies below a set ESG threshold (below a specific ESG score). Using this strategy could mean that you are not avoiding an entire sector but are only investing in the best companies in there. Take the oil & gas sector, for example. Total, the French oil company, is considered a leader in the oil & gas industry. Their ESG score (provided by some of the ESG rating agencies) could be high enough for certain asset managers to include it in their funds. Investors using positive screening are often criticized that they do not maximize positive impact this way and only use the strategy as risk management to mitigate the downside. Still, this strategy is considered successful, especially if you combine both the negative (SRI) and positive screens for your investments, which gives you something closer to an ESG integration strategy.
- Active ownership: The active ownership strategy means investing in companies with harmful practices to influence them by voting in their board meetings to change their strategy. For example, it could mean that you invest in an oil & gas company and vote during their shareholder resolutions to advocate the transition to renewable energy solutions. You could achieve this by investing in funds whose managers are known to vote in line with your values. In this way, you could be following a market index that is fully diversified by including a wide range of companies in your portfolios. However, you need to be careful following this strategy as some investment managers don’t walk the talk. Some asset managers are re-branding their traditional investment funds as ESG funds. However, they are not voting in line with what they are promoting, and this practice is called greenwashing. If you want to pursue this strategy successfully, you need to check the investment funds and investment managers and need to follow up with the managers if you feel that your values are not represented in boardrooms.
- ESG integration: ESG integration integrates ESG factors into traditional investment processes to improve long-term portfolio risk/return. When done right, ESG integration is the next evolutionary step in sustainable investing from socially responsible investing. It also avoids the sectors where your values are not aligned while also allowing you to invest in the best scoring companies from an ESG perspective. While there is no perfect framework for ESG integration, efforts are being made by the CFA Institute and the Principles for Responsible Investment (PRI) to create “a best practice report” for equity and fixed income investments. The Task Force on Climate-Related Disclosures (TCFD) also provides resources for ESG investors as well as the 2° Investing Initiative with their Paris Agreement Capital Transition Assessment (PACTA) tool.
3. Impact Investing
According to the Global Impact Investing Network’s official definition, “impact investments are investments made to generate positive, measurable social and environmental impact alongside a financial return.” Impact investing is always very specific, targeting a selected issue resulting in a thematic investment strategy. These issues often align with the United Nation’s Sustainable Development Goals or SDGs – such as gender equality, climate action, no poverty, or reduced inequalities. There are 17 goals in total, and multiple investment managers chose this framework to showcase their impact investing strategy. There are two very distinct strategies of impact investing which is differentiated by their financial return potential: thematic impact investing and impact first investing.
Impact Investing – Thematic impact investing
If you want to pursue an impact investment strategy where, besides the targeted environmental and social impact, you like to outperform the market and aim for high financial returns, you are following thematic impact investing. There are specialized active fund managers who pursue this strategy and regularly monitor their portfolio companies to ensure impact is generated along with their expectations. Targeted themes include, amongst many others, healthcare, climate change and microfinance.
Impact Investing – Impact first investing
If you, besides the targeted environmental and social impact, are potentially willing to sacrifice some (but not all) of the financial returns and earn a below-market rate with your investments, you are pursuing the impact first investing strategy. The goal here is to preserve your money with some financial return while aiming for a high impact. It is important your goal is not to lose your money with your investments. If you are losing your money, then it is the same category as philanthropy or a charitable donation, and you are no longer investing sustainably. Impact first investing can be powerful, and strategies include investing in social enterprises. There are not many investment vehicles on the market doing impact first investing, and they are currently primarily available for professional investors. Impact investing is the most effective sustainable investing strategy.
The biggest challenges of sustainable investing
While sustainable investing has undoubtedly become exceedingly popular, and many argue it is already mainstream, there are several challenges to overcome before sustainable investing can be considered the norm.
1. Beware of greenwashing & impact washing
Sustainable investing became so popular that many new financial products were “created.” Essentially existing products were repackaged, and funds repurposed under a green label. These funds are watered-down in terms of ESG and impact. They often contain the same old environmentally and socially destructive sectors and companies, now under a green label. This practice is called greenwashing, and unfortunately, you need to be vigilant to avoid it.
There is a whole rating industry built around sustainable investing that rates companies based on their ESG practices. These are called ESG rating providers. They provide a rating for each company they are tracking based on company ESG related disclosures. They are the ones defining what ESG is at the end of the day. Based on these scores, asset managers can evaluate which companies they want to invest in. Unfortunately, ESG ratings can be unreliable, mainly due to the companies’ lack of disclosures. Companies are not required to report many of the necessary figures as regulations have not caught up with the sustainable finance industry. Therefore, investment managers often employ their ESG specialists who rate companies based on their proprietary framework.
ESG ratings are used for the SRI and ESG Investing strategies. Still, impact measurement is also one of the biggest challenges faced explicitly by the impact investing community. Given there are no set of rules accepted by regulators that are enforceable, it is up to the asset managers to decide which framework they want to pursue. There are many frameworks for impact measurement, such as IRIS by the Global Impact Investing Network, and the Operating Principles for Impact Management developed by public and private sector participants. Another widely used method by asset managers to measure impact is to map each company’s revenue with the UN SDGs and report their performance in line with the investment companies’ revenue contributions to the SDGs. “Impact washing” is a real issue. Regardless of how asset managers measure impact, it is still imperative for investors to check what they are investing in.
2. Sustainable investing is much more than investing in renewable energy
A huge myth is that sustainable investing equals investing in renewable energy. In reality, it is much more than that. Social and racial equality, human rights, working conditions, animal welfare and biodiversity, are just a few of the things you could target with sustainable investing.
Climate change is one of the most pressing challenges we face as humanity. We need to prepare for a just transition to renewable energy solutions. Nonetheless, you should be careful when constructing your portfolio. If you focus on a specific sector or a particular set of companies, you could expose yourself to a company or sector-specific risk that could hurt your financial returns in both the short and long term. Be careful when financial products market themselves as “green,” “clean,” or “climate” as very often it only means that they mainly invest in renewable energy.
Recently, investment managers are being scrutinized if they put enough focus on the S (social) in ESG. Since the start of the pandemic and the increased attention on social issues during 2020, the attention has shifted from environmental issues towards social ones. The focus on all three elements of ESG (environmental, social and governance) is essential to tackle today’s issues and drive real change on a global scale.
3. Limited investment options for everyday investors
There is a known scarcity of ESG funds that are large enough and well-managed by investment managers. Many funds are inauthentic and have a poor conviction on SRI, ESG or impact. While the equities space is growing and there are more and more funds launching, it is more difficult to find good, fixed income investment options.
However, the most impactful funds are private vehicles, meaning that they invest directly into privately-owned companies that are not publicly traded on the stock exchanges. The current financial regulation does not let asset managers make these funds available for retail clients. It is only for professional, institutional investors, or high-net-worth individuals whose portfolios are otherwise well diversified. Regulators argue that these high impact funds are too sophisticated or not diversified enough and hence carry too much risk for the retail investors.
About FLIT Invest
FLIT Invest is the first automated investment service to capture the whole spectrum of sustainable investments, from SRI through ESG to impact investing. We also believe that in 10 years, sustainable investing will just be investing. Our mission is to empower the next generation of investors to build wealth by promoting sustainable investing and financial literacy. Our vision is to democratize wealth management and to create the NextGen sustainable finance ecosystem. We believe that “the future will be green, or it will be not at all.”