Sustainable Investing

Sustainable investing is no longer a niche investment approach. Growth has rapidly increased over the last 20 years (see graph at right)[1]. In a 2015 survey, the Morgan Stanley Institute of Sustainable Investing found that 71% of individual investors are interested in sustainable investing[2]. Sustainable investing seeks to provide strategies, products and solutions that help investors realize their vision of a better world. Unfortunately, corporate sustainability practices vary widely and are difficult to quantify. Generally, sustainability encompasses behaviors, processes, tools and technologies that achieve economic, social or environmental benefits. Investors then give capital to these businesses in order to align their investments with their personal values.

One big challenge to sustainable investing is that there is no single agreed-upon definition of what makes an investment sustainable. In fact, the definition of sustainable investing has changed over the years from excluding “bad” companies to proactively investing in “good” companies with certain sustainable goals (i.e. lower carbon footprint, more diversity in the work place, etc.). The older way of sustainable investing excluded companies from the portfolio for certain moral or ethical issues like alcohol, tobacco, gambling and fossil fuels. Companies that many investors think of as “good” were never specifically included. Though that model has changed.

Today, there are more direct and proactive ways for investors to achieve positive impacts. For example, there is:

1) Environmental, Social, Governance (ESG) integration which is the explicit inclusion of environmental, social and governance factors by portfolio managers into financial analysis.

2) Impact investing which focuses on investments in business models that specifically seek to solve social or environmental problems.

3) Thematic exposure which targets themes or assets specifically related to environmental or social sustainability.

By proactively investing in companies with “good” behaviors investors are trying to change the behavior of companies. Whether it is low-carbon air travel, vertical farming in high-rise structures, or zero-waste buildings and cities, sustainable businesses have the potential to create products and services that transform the way we live. Sustainable investing can be a powerful way to mobilize capital toward positive impacts. While this is not the definitive list, here is a good example of certain sustainable factors[3]:

Another big challenge is the reporting of sustainable practices within corporations are still not standardized. While the data has gotten much better in the last 10 years, companies aren’t required to disclose their sustainable behaviors and associated risks. Standardized metrics are just beginning to be used but aren’t fully-fledged yet. Therefore, a lot of judgment and estimation is required in assessing sustainability metrics. Furthermore, disclosure can be expensive, leading to bigger companies with more resources, being represented at a higher percentage than smaller companies.

Will Performance Suffer?

Research is starting to suggest a connection between corporate sustainability performance and financial performance. A 2014 Harvard study, for example, found that “High Sustainability” companies significantly outperformed “Low Sustainability” companies over the long term. The authors noted that “the integration of [sustainability] issues into a company’s business model and strategy may be a source of competitive advantage for a company in the long run. A more engaged workforce, greater transparency, a more collaborative community, and a better ability to innovate may all be contributing factors”[4]. In addition, a Morningstar study showed sustainable mutual funds outperforming ones that aren’t[5]. You don’t have to rely on studies though. Real world result of the MSCI KLD 400 Social index, which includes stocks with high environmental, social and governance ratings versus the S&P 500 Index shows the KLD index slightly outperforming. In general, we think that returns won’t be affected one way or the other.

How to we incorporate ESG?

We mainly use ESG criteria in developing portfolios for clients (as opposed to thematic or impact criteria). We rely on third party data from Sustainalytics which rates individual companies one by one to identify company-level ESG scores. A mutual fund or exchange traded fund can then be rated by the underlying ratings of the companies it holds. This allows us to screen for high ESG ratings and allows us to monitor and report on ESG scores.

In addition, we rely on specific indexes to implement ESG factors into their methodology. The factor scores are determined by the quality of the data they receive and the specific issues they screen for. Here is an example of how MSCI, a popular index provider, screens for ESG factors.

Another option for clients is to track an index through ownership of individual stocks. Instead of owning a fund that holds the individual stocks, we can cut out the fund and own the stocks ourselves. We can even exclude specific sectors or companies based upon your personal values.

Conclusion

According to Morningstar, only about 2% of funds have an explicit sustainable mandate. As investors are better able to assess how well companies manage their ESG factors, more capital may potentially flow to companies with the higher sustainable practices. And as more capital is attracted to sustainable investing, more companies may find it worthwhile to invest the time and money to invest in sustainable practices. Investors “voting with their dollars” could force some of the bad actors to make corporate decisions with not only money in mind, but sustainability too.

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This  is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

INDEX DEFINITIONS

The Standard & Poor’s 500 Index 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. It cannot be invested into directly.

The MSCI KLD 400 Social Index is a capitalization weighted index of 400 US securities that provides exposure to companies with outstanding Environmental, Social and Governance (ESG) ratings and excludes companies whose products have negative social or environmental impacts.

[1] US SIF Foundation; Bank of America Merrill Lynch Global Research, “ESG: Good Companies Can Make Good Stocks” Dec. 18 2016

[2] Morningtar

[3] Environmental, Social and Governance Issues in Investing: A Guide for Investment Professionals, CFA Institute

[4] Morningstar

[5] Wall Street Journal, data from Morningstar