Two senior ladies hiking in the woods

The popularity of responsible investment (RI) strategies has undergone a meteoric rise in recent years. According to the Global Sustainable Investment Alliance’s Global Sustainable Investment Review, 2018, $2.1 trillion in sustainable investments were held in Canada at the start of that year, a 42% increase from 2016. Sustainable investments in Canada that year accounted for 50.6% of professionally managed assets, up from 38% in 2016.

RI strategies – which can encompass a variety of environmental, social and governance (ESG) metrics – are particularly popular among younger investors. Research from New York-based Morgan Stanley & Co. LLC found that millennials are more than twice as likely as the overall investor pool to invest in companies targeting ESG outcomes.

As RI continues to gain ground, it inevitably will play a larger role in helping investors – particularly today’s younger investors – meet their retirement goals. The idea of giving RI investors preferential tax treatment has even been floated by Canada’s Expert Panel on Sustainable Finance, which proposed a “super tax deduction” for retail investors who hold climate-friendly investments in their RRSPs.

But, if the goal is to invest responsibly and save enough to retire in comfort, can RI investors have their cake and eat it too?

A wealth of data suggests they can.

A 2018 report from Chicago-based Morningstar Inc., which studied 351 RI funds, found that 63% of those funds finished in the top half of their asset classes relative to their peers and only 18% finished in the bottom quartile. Morningstar states these results are consistent with academic research that found there is “no systematic performance penalty associated with sustainable investing.”

Indeed, a 2015 meta-analysis of 2,000 empirical studies on RI’s impact on financial performance, published in the Journal of Sustainable Finance & Investment, found that 63% of the studies found RI investments had a positive impact on investment returns and only 8% had a negative impact, while the other studies found RI had no meaningful impact on returns.

In spite of such data, some investors – and their financial advisors – still believe that RI leads to poorer returns.

“From what we’re seeing and hearing in the market, there is still a perception – what we call the ‘performance myth’ – that exists,” says Dustyn Lanz, CEO of the Responsible Investment Association (RIA) in Toronto. “In some cases, it might be among the investors; but certainly in some cases, it’s actually at the advisory level.”

Lanz suggests this misperception could boil down to an outdated understanding of how RI works: “It’s quite possible that a lot of advisors and investors who buy into this performance myth might just assume that [RI] means exclusions, when that’s actually not the case. That’s one approach – that’s more of the values- or ethics-driven approach – but that’s one approach of many.”

Exclusions (a.k.a. negative screening) weed out certain businesses, such as weapons manufacturers or tobacco producers, from an RI fund or index, as well as excluding companies embroiled in controversies such as unethical business practices or irresponsible environmental policies.

But, Lanz notes, other ways of incorporating ESG metrics into investment decisions include ESG integration, in which companies’ ESG ratings are considered alongside other financial metrics; positive screening, which selects best-in-class companies based on ESG performance; and shareholder engagement.

Tony Campos, head of ESG, Americas, with London-based FTSE Russell International Ltd., says negative screening still is used in RI, but notes that it’s “not really the way sustainable investing is done today exclusively.”

Adds Campos, who works in the firm’s New York office: “The methodologies have moved on. The sophistication of the underlying data, and the scoring and rating of companies, has moved on. But in a lot of people’s minds, when they hear ‘ESG’ or ‘sustainable investing,’ they’re going to think back to the way it was done a long time ago.”

FTSE Russell has been active in ESG benchmarking since 2001. The firm now licenses a variety of ESG indexes, such as the FTSE ESG index series, which is industry-neutral and has no exclusions; and the FTSE4Good index series, which includes companies based on strong ESG performance and excludes others based on weak performance.

“If we think about just the FTSE Russell indices,” Campos says, “there’s often, at the very least, a combination of positive selection, which means selecting companies based on their positive ESG performance alongside some of the lighter-touch, negative screens that are used to try to get a more complete picture of what ESG selection and strategy should try to accomplish.”

Excluding companies from an index or investment fund specifically because they are involved in controversial business practices isn’t just a matter of ethics, says John Bai, vice president and chief investment officer for both Northwest & Ethical Investments LP and its Toronto-based parent, Aviso Wealth Inc. Such exclusions can also lead to less volatility in an investor’s portfolio – something that can be particularly attractive to people who are saving for retirement.

“RI companies tend to be lower-volatility, higher-quality companies that hold up better in difficult market conditions,” Bai says, adding that NEI’s RI mutual funds exclude companies that, for example, have poor environmental records or questionable governance practices. “We just avoid those types of headline risks,” Bai adds.

The business case for avoiding companies with poor ESG records is illustrated in research conducted by New York-based asset-management firm New Amsterdam Partners LLC, which identified a strong negative correlation between high ESG ratings and stock volatility, and found that this lack of correlation became more pronounced when market volatility was higher.

“When you see companies in the news, it’s [often] because somebody did something wrong,” says Charlene Birdsall, investment advisor and portfolio manager with Montreal-based National Bank Financial Inc.’s wealth-management division in Winnipeg. “With the negative news, the stocks become more volatile – and that’s not what we want to see. People don’t like seeing their portfolios go up and down consistently.”

Birdsall is an RIA member who holds the association’s responsible investing certification. She says clients who are interested in RI – mostly younger women in Birdsall’s practice – aren’t generally concerned about their investment preferences having a negative impact on returns.

“If they’re interested in [RI], that’s where they want to put their money,” Birdsall says. “They have us, as advisors, to pick the best stocks that would get them the best bang for their money, keeping responsible investment in mind.”

For the most part, though, Birdsall says clients need to be directed toward RI. “It actually has to be brought to their attention. People don’t just come out and ask, ‘Do you have any responsible investments available?'” Birdsall says. “Clients don’t know that there are investments out there [through which] you can put your money where your values are.”

Birdsall has only two clients who sought out her services specifically because of her expertise in RI. One of those clients was interested in RI but didn’t think her previous advisor knew much about it. However, Birdsall doesn’t believe that other advisors are necessarily discouraging their clients from becoming responsible investors: “I don’t think [advisors] are turning clients away – I just don’t think [advisors] have the knowledge or the tools to help [their clients].”

Some advisors may have some catching up to do to meet growing client interest in RI. This year, the RIA commissioned Ipsos Group SA to survey approximately 1,000 Canadians regarding their investment preferences. Seventy-nine per cent of survey participants said they want their financial services providers to inform them of RI investments that are in line with their values.

“This data is in line with our previous research, which found that the vast majority of Canadian investors are interested in RI, but [also] that the vast majority know little or nothing about it,” Lanz says. “So, there’s this huge gap between clients’ level of interest [and] their knowledge of RI.”

To help bridge that gap, the RIA took part in the Canadian Securities Administrators’ 2018 consultation on proposed client-focused reforms, advocating for know-your-client (KYC) regulations to be updated to require advisors to ask clients about their ESG preferences.

“A mandated question about ESG would be good for investors because it would make them aware of an option that they’re likely already interested in hearing about, based on the data that we found, and it would be good for advisors because it would help them give suitable advice,” Lanz says. “The whole point of the know-your-client process is to know the client. So, if a client is interested in responsible investing and the advisor doesn’t know that, then I would argue that the advisor doesn’t know their client well enough to give suitable investment advice.”

In the meantime, Lanz is eager to dispel the notion that RI means sacrificing returns.

“I would say RI isn’t about investing solely with your conscience; it’s about merging financial metrics with environmental and social considerations,” Lanz says. “By no means is a responsible investor ignoring financials – it’s quite the opposite. [RI] is considering financial metrics in addition to another layer of information that can be material to investment decisions.” IE