In recent years, Canadians have become increasingly aware of the environmental and social factors affecting their society. In particular, millennials (the cohort that reached young adulthood around the year 2000) are especially interested in values-based societal concerns. As consumers, they are more likely to purchase electric cars, fair-trade coffee, plant-based food and cosmetics that were not tested on animals.
A recent report from the World Economic Forum found that young professionals believe that environmental and social issues account for 5 out of 10 of the most serious risks affecting the world today and that 6 of the top 10 business risks are environmental. However, these concerns are not just limited to younger people. A recent KPMG survey found that company CEOs consider climate change and other environmental risks to be among the top five threats to growth.
These changes in societal attitudes are also having a wider impact on the investment industry. According to RIA, Canada’s industry association for Responsible Investment, Canadian Responsible Investment assets exceeded $2 trillion dollars as at December 31, 2017. This represents growth of more than 400% over the course of the past 7 years.
Investors should take note of these developments, regardless of their personal societal aims and humanitarian proclivities. Astute investors always attempt to pick out the winners. As millennials and other younger cohorts play an increasingly important role in the macroeconomy, they will in large part be responsible for choosing the winners through their consumption and investment decisions. In essence, businesses that are responding to the changing tastes and preferences of the next demographic wave are more likely to succeed in the long-term and so investors should consider incorporating these factors into their portfolio management philosophies.
In this edition of the Canadian Financial Planner, we shall discuss Responsible Investment, how it is defined and some of the strategies used by investors wishing to incorporate these types of assets into their portfolios. We will also consider Impact Investment, a subset of Responsible Investment, whereby investors look to earn a financial return, while also seeking to generate beneficial social and environmental impacts. Finally, we will discuss the Responsible Investment marketplace and various portfolio options available to investors, together with a few possible pitfalls to consider.
Specifically, we will discuss:
- PART 1: Responsible Investment
- PART 2: Impact Investment
- PART 3: The Canadian Responsible Investment Marketplace
PART 1: Responsible Investment
Responsible Investment (RI), also known in the investment industry as Socially Responsible Investment (SRI), refers to the approach of incorporating metrics of social and environmental responsibility into the analysis of investments, in order to avoid organizations and industries that tend to have a negative impact on the environment, or society as a whole.
Proponents of RI invoke ESG (environmental, social and governance) factors when evaluating companies as investment prospects. For example, imagine an investor is looking to assess a number of company stocks to determine their level of social responsibility. What criteria could the investor be using to evaluate the company? Using the ESG framework, they might consider some of the following issues.
- Energy consumption
- Waste output/ pollution
- Climate impact
- Preservation of natural resources and areas of natural beauty
- Animal welfare
- Engagement with local communities
- Employee relations and working conditions
- Human rights/ fair trade
- Gender/ ethnic diversity and tolerance of minorities
- Health and safety
- Relations with corporate stakeholders
- Competence of senior management
- Independence of board of directors and conflicts of interest
- Executive compensation
- Shareholder rights
- Corporate transparency and disclosures
- Governing philosophies, such as corporate social responsibility and social enterprise
While this list is far from exhaustive, it highlights the types of aspects that an investor, or fund manager, might examine when evaluating an investment under RI criteria.
Responsible Investment market growth
Responsible Investment is growing quickly in Canada and internationally. The most recent Canadian Responsible Investment trends report published by RIA, showed that Canadian assets being managed using one or more RI investment strategies had risen by 41.6% over a two-year period to $2.13 trillion. Further, RI assets now account for 50.6% of Canadian assets under management. The figure for US RI assets under management was over USD$22 trillion at the beginning of 2016, a 25% increase over the prior 2 years.
Not only are investors increasingly managing some, or all, of their assets using an RI strategy, but investor surveys now show that a significant majority of investors would consider allocating at least some part of their portfolio to RI. The market growth and current investor sentiment point to RI becoming a more significant feature of the investment industry landscape in future. Furthermore, this data appears to align with social attitudes more common to young and upcoming demographic groups.
Tip: The industry figures should perhaps be taken with a pinch of salt. In reality, whether or not a given security is considered a “Responsible Investment” for the purposes of categorization is not black and white; it involves shades of grey, incorporating personal value judgements. We discuss this aspect of RI in greater detail in PART 3.
How Responsible Investing works
There are various strategies used by investors and fund managers to build and maintain RI portfolios. There is no one approach, or standard, used to determine what constitutes a Responsible Investment or an RI strategy. Nevertheless, some of the more common investment strategies are discussed below.
Investors and fund managers explicitly incorporate ESG metrics into their financial analysis process. In essence they expand the number of variables that they use to pick portfolio securities to include measures of social responsibility and conscientious corporate governance, in addition to more traditional measures of financial performance.
In this case, investors pick a “theme” to help them decide which securities to include in their portfolio. For instance, an investor might decide that they want to build a portfolio that only includes securities in the renewable energy sector. Alternatively, the theme might not be sector specific; for example, an investor might decide to only buy stocks in companies that have diverse hiring and internal promotion policies. In the latter case, the investor might be choosing securities in various industries, nonetheless, the unifying theme is the diversity of employees and upper management.
The investor applies a “negative screening” approach to selecting portfolio assets i.e. individuals intentionally avoid investing in organizations that run counter to their personal values. Examples of a negative screening approach might be to eliminate investments in tobacco products, firearms producers, organizations that use child labour, or heavy polluters. The screening applied will likely be personal in nature and reflective of an investor’s private beliefs and attitudes. Negative screening is a relatively passive approach, that aims to do no harm, while still generating a financial return for the investor.
Here, the investor would select only securities that align with their personal values and/ or score highly on ESG metrics. The difference between this approach and negative screening is that the investor is actively selecting securities that meet the RI criteria, rather than excluding those that do not. Positive screening is generally a more activist approach to picking securities and is also commonly associated with Impact Investment, which is discussed in PART 2.
Shareholders may be able to exert pressure on company directors and ultimately influence corporate behaviour. With reference to ESG criteria, activist shareholders can exercise their voting rights, speak up in shareholder meetings and file proposals with the board to help shape company policies to align them more directly with RI measures.
In January 2000, SustainAnalytics launched the Jantzi Social Index (JSI) in partnership with the Dow Jones indexes. The JSI is a “socially screened, market-capitalization weighted common stock index modeled on the S&P/ TSX 60”. It consists of 50 Canadian companies that have been selected based on a broad range of ESG criteria.
Over the course of almost a decade, the JSI has consistently outperformed the S&P/ TSX Composite and S&P/ TSX 60 indexes, with the overall effect becoming more pronounced over time. This alludes to the fact that incorporating ESG metrics into a portfolio management strategy may result in strong financial performance, in addition to promoting improved social and environmental outcomes. This follows the logic that companies being governed in a way that aligns with evolving societal values and preferences are more likely to be “ahead of the curve” in various ways over and above their competition.
Nevertheless, the JSI index, as with any portfolio selected using an RI strategy, was chosen based upon certain value judgements. Since these judgements are subjective in nature, there can be no single formula for building and managing an RI portfolio.
PART 2: Impact Investment
According to the Global Impact Investment Network (GIIN), Impact Investment refers to “investments made with the intention to generate a positive, measurable social and environmental impact alongside a financial return”.
How does Impact Investment differ from Responsible Investment?
Impact Investment is a subset of Responsible Investment. The key differences between the two revolve around the strategies used to select portfolio assets, as well as the expectations of financial return. Investors looking to build an Impact Investment portfolio are likely to be using a positive screening approach, as opposed to a negative screening one.
Impact Investors are generally characterized as being more activist; they actively chose securities to include in their portfolios by evaluating the social and environmental contributions expected from these investments, together with expectations of financial return.
This contrasts with a typical RI style, whereby the investor is more commonly excluding only those investments that violate the ethical framework established by their ESG analysis. Further, investors using an RI strategy are generally aiming for solid portfolio returns. RI portfolio managers have a duty to their clients to maximize their returns, subject to the constraints set out in their portfolio management strategy. Conversely, there is a range of financial return expectations among proponents of Impact Investment. Some investors may be willing to accept below-market returns in exchange for greater social or environmental impact (i.e. a greater weighting is assigned to societal impact vs. financial return than under an RI model).
Impact Investment market growth
According to RIA, Canadian Impact Investment assets grew 81% from $8.15 billion at the end of 2015, to $14.75 billion at the end of 2017. While growth has been significant, Impact Investment assets still account for less than 1% of the total Responsible Investment market.
One of the key issues with Impact Investment centres on how to objectively measure impact. Some more sophisticated investors have built frameworks to help them measure and record impact metrics, but it is still very common for investors to have little success in tracking these measures consistently.
There are some global frameworks that are gaining in popularity, such as IRIS+ as well as the UN’s Sustainable Development Goals (SDGs). Adopting some common standards for measuring impact would clearly be hugely beneficial to investors, making a range of investments much easier to compare. However, adoption of these types of metrics is still haphazard, with many different organizations opting for impact measures of their own. The industry has a way to go before there are widely adopted common standards.
Another concern is that societal impact may be hard to objectively measure. How does one measure the quality of community engagement that a particular company is demonstrating? Could we measure it by the number of meetings that are being held between company officials and community groups? Surely that would not capture the extent to which the company is listening and reacting to the concerns of local citizens. Clearly, not every important dimension is measurable or readily comparable.
Tip: Given the increasing popularity of Impact Investment, public equity markets have woken up to it being an important driver for a key segment of prospective investors. Some public issuers may only be paying lip service to their commitment to social or environmental impact. This phenomenon is known as “impact washing” and has arisen as a direct consequence of the lack of consistency and comparability of impact metrics across the industry. Investors should be wary of the verbiage being used in a prospectus and try to tease out what the company has accomplished that is actually measurable.
In the trade-off between financial performance and impact, Impact Investment adopts a heavier weighting in favour of societal impact relative to that of Responsible Investment. As a result, one would expect returns to be lower.
MSCI, an international provider of investment decision support tools, maintains a global Sustainable Impact Index. It aligns its measures of impact with the UN’s SDGs, identifying companies that derive 50% or more of their revenues from activities that address environmental and social challenges. Over the course of the last four years, the baseline global equities index marginally outperformed the Sustainable Impact Index, but only by a small fraction. The annualized return since inception of the global Sustainable Impact Index was 8.64%, compared to the baseline index at 8.8%.
RIA, Canada’s Responsible Investment industry body, conducted a survey to determine how Impact Investments performed relative to expectations. Notably, 98% of survey respondents indicated that their portfolio performance met or exceeded their expectations. These results are difficult to interpret since every investor has different expectations but are nonetheless encouraging.
The index and the survey results appear to support the contention that the cost to the investor of seeking improved societal outcomes may not necessarily be overly punitive in terms of forgone investment returns. Clearly this would depend on the investor’s specific portfolio choices and investment priorities; nonetheless, achieving investment growth and pursuing impact goals do not appear to be mutually exclusive.
PART 3: The Canadian Responsible Investment Marketplace
In Canada, Responsible Investment assets are allocated broadly. Approximately one third of the market is comprised of public equities, one third fixed income securities and the remainder is divided between private equity, venture capital, real estate and other assets.
While a majority of RI assets are held by institutional investors, there has been significant growth in individually held RI assets under management. Canadian retail RI mutual fund assets now exceed $11 billion, venture capital assets over $13 billion, and ETFs around $240 million.
Most major financial institutions have a wide variety of RI mutual funds and ETFs available to retail investors. A few examples of these types of funds include:
- Desjardins RI USA – Low CO2 Index ETF
- CIBC Blue Heron Dividend ESG Leader
- BMO Sustainable Opportunities Global Equity Fund
- RBC Vision Women’s Leadership MSCI Canada Index ETF
- NEI Jantzi Social Index Fund
Investors seeking RI funds to invest in can work with their financial institution, investment advisor or can start by shopping online for RI vehicles to suit their needs. RIA has an online marketplace where investors can filter funds by RI strategies, negative screens, asset classes, risk ratings and more (details can be found at the following website: www.riacanada.ca).
Investors looking for Impact Investment options can peruse the OpenImpact website. However, OpenImpact is uncurated and the funds listed are self-reported as Impact Investments. As such, prospective investors will need to exercise extra caution and complete their own due diligence process before deciding whether or not to invest; see the following website for more information (www.openimpact.ca).
For Impact Investors that are interested in private market securities, there are other popular online platforms, including:
- SVX – a platform for Canadian Impact Investment funds (www.svx.ca)
- ImpactBase – online database of global Impact Investment funds (www.impactbase.org)
- ImpactAssets 50 – online database of Impact Investment fund managers and online education resources for investors and financial advisors (www.impactassets.org)
Of course, there is always the option of managing one’s own portfolio. This has the upside of allowing investors to apply a very specific set of criteria to their portfolio decision-making. Nonetheless, there can be a lot of work involved in continually researching, maintaining and rebalancing an investment portfolio. Further, investors that are looking to take the shareholder engagement route to responsible investing will most likely find that they convey much more clout when pooling their assets with other investors in a fund.
Principles for Responsible Investment
The enormous growth in retail RI investment is not necessarily the result of a massive influx of investor assets into these funds. Rather, many investment firms have implemented an ESG integration strategy across all of their assets, including retail funds, even where they may not be marketed as Responsible Investments. In other words, investment firms are increasingly building ESG metrics into their investment analysis frameworks, ostensibly resulting in more socially conscientious investment practices across the board.
In particular, many investment firms are signatories to the United Nations backed Principles for Responsible Investment (PRI). The PRI defines Responsible Investment as “an approach to managing assets that sees investors include environmental, social and governance (ESG) factors in their decisions about what to invest in, and the role they play as owners and creditors”.
Tip: For an investment firm, adopting an ESG integration strategy only requires them to apply some sort of weighting to ESG factors when building their investment management models. This is to say nothing of the amount of weighting applied. A firm espousing ESG integration may not necessarily be notably different from other investment firms. Investors may need to look further into the portfolio options available before characterizing any particular funds as Responsible Investments in any meaningful sense.
As discussed, the Canadian investment industry appears to be widely embracing ESG integration. However, this approach has nothing definitive to say about whether certain investments should be included or excluded from an RI portfolio. Specific value judgements, such as “no tobacco producers”, or “no heavy polluters” would not necessarily be captured by an ESG centric approach alone. For value judgements to be properly reflected, negative screening would likely be required.
These days, there are many mutual funds and ETFs that apply negative screens. For example, the RBC Vision Global Equity fund has the following negative screens:
- Weapons/ military;
- Pornography; and
Since there are so many different types of RI funds available with a wide range of negative screens, investors have a good chance of being able to find vehicles that cater to their personal preferences.
One concern with pursing an RI strategy is that investors may end up with portfolios that are less diversified than they might otherwise be. For example, an investor may decide to pursue a thematic RI strategy, investing primarily in “green” technologies. While this may be a laudable goal, it could expose the investor to additional asset concentration risk. Green technology securities are more likely to be similarly affected by changes in government subsidies, the regulatory environment, or certain tax laws. When stock prices in a particular portfolio have a strong tendency to move up and down together in response to the same stimuli, there is clearly a need for further diversification.
Tip: One possible approach to help mitigate portfolio diversification problems is to adopt a “best in sector” approach. Most industries have their stars and their laggards; investors could aim to select investments from a wide range of sectors but focus only on the star performers, viewed through the lens of personally held values.
As discussed previously, much of the determination as to what is and what is not a Responsible Investment depends on personal value judgements. Whether the RI strategy is ESG integration, positive/ negative screening, thematic, or otherwise, the fact remains that investors must decide for themselves whether a particular security or fund is socially responsible or not. Investors should take care when looking at much of what the investment industry distributes, since it often fails to capture these types of nuances; often preferring to discuss investor options in black and white terms.
WARNING: This information is for educational purposes only. As it is impossible to include all situations, circumstances and exceptions in a newsletter such as this, a further review should be done by a qualified professional. No individual or organization involved in either the preparation or distribution of this letter accepts any contractual, tortious, or any other form of liability for its contents or for any consequences arising from its use. Photocopying, replication or any other reproduction of the information contained within the newsletter, for any reason, other than a single page for reference only is strictly prohibited. Copyrighted © 2019. Date of Issue – November 2019. This periodical is published four times per year in March, July, September and November.
Responsible Investment and its more activist subset, Impact Investment, are important developments in the investment industry. Astute investors should take note of these changes as they reflect an evolution in attitudes, driven by moving demographics that will likely have far-reaching macroeconomic effects. Much of the emerging data appears to show that achieving investment growth and pursuing improved social and environmental outcomes are not mutually exclusive goals. Nevertheless, investors should exercise caution when making portfolio decisions to ensure that the RI strategies being implemented align with their personal values, while ensuring that their investments do not ultimately become under-diversified.
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