As citizens, individuals can express their political preferences around sustainability through the ballot box. As investors, they also can express their preferences through participation in global capital markets. One key question these investors face is how to do this without compromising their desired investment outcomes. For instance, how can they reduce their portfolio’s environmental footprint while maintaining sound investment principles and achieving their investment objectives?
Sustainability preferences are not generally restricted to greenhouse gas emissions. Many investors may also have concerns about land use and biodiversity, toxic spills and releases, operational waste, and water management, among other issues. Furthermore, many sustainability minded investors also seek to exclude companies associated with certain social issues such as tobacco, alcohol, gambling, adult entertainment, child labour, factory farming, nuclear weapons, cluster munitions and landmines. Thus, it is a challenge to achieve the dual goal of efficiently considering sustainability preferences while building investment solutions that help meet investors’ financial goals. One way to approach this challenge is to focus first on developing an investment methodology that emphasises what research indicates are reliable sources of higher expected returns while also aiming to minimise unnecessary turnover and trading costs. For instance, in equity portfolios, this may mean starting with a broad universe of stocks ranging from very large companies to very small companies, and then systematically pursuing higher expected returns by increasing the weights of those securities with smaller market capitalisations1, lower relative prices2, and higher profitability.3
Next, investors can evaluate those companies being considered for investment using a focused set of environmental issues that reflect their primary concerns. Again, using equity portfolios as an example, by using a holistic scoring system, rather than a completely binary “in” or “out” screening process, investors may be able to preserve diversification while recognising those companies with positive environmental profiles. This involves looking at companies across the entirety of a portfolio and within individual sectors with the goal of incorporating sustainability preferences while also maintaining the characteristics of the original strategy. For example, if one is trying to reduce a portfolio’s greenhouse gas emissions and potential emissions from fossil fuel reserves, the worst offenders across all industries may first be de-emphasised or excluded from the portfolio altogether. An across-industry comparison of this nature provides an efficient way to significantly reduce the aggregate greenhouse gas emissions per unit of revenue produced by companies within a portfolio with a minimal reduction in diversification. Next, companies may also be rated on sustainability considerations within each industry. This added level of scrutiny is recognition that, in the real economy, capital markets and the supply chain are highly interconnected. For example, a retail company may consume electricity from a utility company and transportation services from a trucking company, both of which are consumers of fuel from an energy company. Comparing companies within sectors recognises this interconnectedness and can be used to overweight the most sustainable companies within a given industry. This could include retail companies that improve the energy efficiency of their facilities, utilities that produce electricity using solar or wind power, trucking companies that improve the fuel efficiency of their fleets or use alternative-fuel vehicles, or energy companies that increase efficiency, reduce waste, and improve their overall environmental footprint. On the other hand, companies with poor environmental sustainability ratings relative to industry peers may receive a lesser weight or may be excluded.
Using such a combination of company selection and weighting may allow for substantial reduction in exposure to greenhouse gas emissions and potential emissions from fossil fuel reserves—important goals for many investors—while providing a robust investment strategy that is broadly diversified and focused on the drivers of expected returns.
When considering social issues, we can take more of a black-and-white approach, as these issues tend to encompass only a small subset of companies in the portfolio. Companies that draw a significant proportion of their revenues from tobacco, alcohol, gambling or adult entertainment can be excluded altogether, with the aim to target producers in these areas, rather than say a supermarket chain that derives a small proportion of revenues from these areas. However other issues, such as controversial weapons, can be approached by excluding companies with any tie to this area.
The key takeaway for investors is that investing well and incorporating values around sustainability need not be mutually exclusive. By starting with a robust investment framework, then overlaying the considerations that represent the views of sustainability-minded investors, investors may have the ability to pursue their sustainability goals without compromising on sound investment principles or accepting lower expected returns.
1. Market Capitalisation is the total market value of a company’s outstanding shares, computed as price times shares outstanding.
2. Relative price as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios.
3. Profitability is measured as operating income before depreciation and amortisation minus interest expense scaled by book equity.
Source: Dimensional Fund Advisors Ltd.
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Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful. Diversification neither assures a profit nor guarantees against loss in a declining market.
Environmental and social screens may limit investment opportunities. Small cap securities are subject to greater volatility than those in other asset categories.