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Why is ESG-rated investment such a hot topic? Does your 401 (k) account allow ESG investment?

By Prathapan Bhaskaran on Oct 05, 2021 | 05:35 AM IST

ESG-criteria investing

Analyze fund choices to ascertain the ESG credentials of firms in the portfolio mix 

The elements of ESG criteria are often brought closer by evolving regulatory pressures

ESG (environmental, social, and governance) criteria are generating worldwide investor interest as our scientific evidence on the need for a sustainable living keeps piling up. Investors wishing to align their portfolios with ESG values are digging ever deeper into the working of companies. The transition in the population, in general, is finding resonance in its upper age bands also. Even working Americans who generally hold the bulk of their retirement money in a 401(k) or the other employer-sponsored retirement savings plan, need not worry about aligning their portfolios with ESG values.

With some diligence, they can incorporate ESG into the retirement-savings strategy both within an employer plan or in tandem with one. This would require analyzing the fund choices within a plan for ESG leanings. If not, they could also start another account to hold ESG investments. Before that, let us find out what is ESG-rated investment and how that is possible. The Wall Street Journal cites Nicole Lee, ESG research head at Miller/Howard Investments, says that when companies pivot to become more sustainable, that boosts the chances that they are going to be relevant and profitable in the long run. However, before jumping in, let us see what is the ESG rage all about.

ESG relationship chart

1.   What is ESG-rated investment?

Investing in a portfolio of shares, debt instruments and/or mutual funds that have a fair percentage of sustainable companies (ESG Investing). It is an exponentially growing area of wealth creation. Investors researching companies and funds for investing increasingly look at their ESG track record. Nicole Lee, head of ESG research at Miller/Howard Investments based out Woodstock, NY, says that firms that look to remain relevant and profitable in the longer term will have to realign their growth strategy to become ESG friendly, according to a report in The New York Times.

2.   What are ESG criteria?

Environmental, social, and governance (ESG) criteria are a set of standards that a socially conscious investor uses to assess a firm’s operations leading to investment. In short, ESG criteria enshrine what a just social order aspires to achieve in all-around development. These three criteria have a lot of overlaps with even the governance criteria borrowing from the other three in the long run.  This is because regulatory pressure that shapes a company’s response to the first two tends to eventually reshape its governance priorities as well.

3.   What does environmental in ESG criteria mean?

Environmental criteria point to how environment-friendly a company’s business plan is. Although profit is the goal of all corporate bodies, an environmentally aware company could guide its business processes through more carbon-efficient pathways. That will reduce the company’s overall carbon footprint and minimize its contribution to global warming and climate change.

4.   What does social in ESG criteria mean?

Social criteria examine a company’s ethos in managing its relationship with employees, suppliers, customers, and the communities in which it operates. It is an indication of the company’s success in meeting its social responsibility. Companies that meet their social responsibility tend to earn the trust of the community in which it operates leading to higher profit in the long run. The trend is to add more regulatory pain to processes that have higher environmental and social costs which in the long run act as disincentives for companies that fail in meeting their social responsibilities.

5.   What does governance in ESG criteria mean?

The governance criteria reflect a company’s leadership, executive pay, internal controls, financial transparency through audits, and measures to protect shareholder rights. It is age-old wisdom that better-governed companies succeed the more. They tend to make processes more efficient and less time and cost-consuming. More efficient processes increase productivity and maximize the profit unit cost of input. Financial transparency and better protection of stakeholder rights tend to synergize company business dynamics and give better returns on investment.

6.   Why ESG-rated investment?

The regulatory ecosystem the world over is turning so very ESG-friendly that it is beginning to affect business bottom lines. Going forward, firms that invest in the policy plank of environment, social responsibility, and governance (ESG) will be the ones remaining profitable in the long run. Legislative pressure will keep adding more pain to non-conformists. Continuing to swim against the current will eventually come under transitional pressure. Therefore, it makes better market sense to invest in companies that have an ESG-rated investment outlook.

7.   How can we ascertain the ESG nature of companies?

Market experts advise us to thoroughly research the ‘green’ claims of the companies for medium- to long-term investment timeframes. The ESG ethos are so interlinked that it’s impossible to separate one from the other. In a report on how ESG criteria create value for world businesses, management consultants McKinsey & Company says the need to think and act on ESG in a proactive manner is becoming more pressing now. The company’s report on US Business Roundtable in August dwells on the emerging trend of ESG-oriented investing. It says the market is experiencing heightened social, governmental, and consumer attention on the broader influence that corporations can have on achieving the Sustainable Development Goals (SDG) of the United Nations.

8.   What is the importance of Sustainable Development Goals (SDGs)?

Sustainability as a development goal has acquired a new urgency in the backdrop of the worsening climate change caused by global warming. A UN report highlights how the world is headed to a catastrophic failure to get to the climate targets by 2030 even if the Paris 2015 promises are met by the major economies. The Glasgow Climate Change Conference, COP26, in Scotland, jointly hosted by Britain and Italy, is likely to advocate more teeth to regulatory efforts of national governments. They could further constrain non-ESG firms and squeeze their margins.

9.   Where can you get info on the ESG rating of companies?

A Morningstar analysis earlier this year said ESG-sensitive funds have “comfortably outperformed” others in their category. Citing a five-year span ending in 2020, it says 77% of ESG-rated equity funds ranked in the top half of Morningstar categories and 49% ranked in the top quartile. Only 10% ranked in the bottom quartile.

The growth of investors’ ESG consciousness has prompted many fund managers to provide advisory on ESG firms. Morningstar’s ranking system that helps identify the ESG-worthiness of funds is useful. It has a one-to-five rating system with five as the best rating. Investors could also reliably turn to MSCI Inc., which has an online ranking system for individual stocks and funds. The categories, “leader,” “average” or “laggard,” is self-explanatory.

10.                Adding the ESG flavor to retirement living

Yes, you can have an ESG-flavored retirement if you do the right research. The first is to look into your current retirement plans to see if there is any ESG-based investment. Few 401(k) accounts may be offering clearly marked ESG focus, they increasingly tend to include at least one ESG-rated fund. Nearly three-fourths of plans include at least one investment choice that gets a high ESG rating from Morningstar, according to Samantha Lamas, the behavioral researcher at Morningstar.

Online literature and portfolio holdings for a fund within employers’ plans yield a lot of information about the ESG profile of their investments. Reference to ESG in the literature is a good indication of the fund’s awareness level. Going through the portfolio to check if the companies in the mix have an ESG track record. Comparing the portfolio with purely ESG-focused funds such as Parnassus Core Equity (PRBLX) or the iShares ESG Aware MSCI USA ETF ESGU 0.85% (ESGU) would make the job easier. It would be wiser to include the companies they embrace. Researching the companies that they shun would also be a good idea if they were rejected because of their weak ESG credentials.

Some employer-sponsored plans allow adding a limited number of companies outside their usual investment bouquet. This will be useful in buying and holding selected individual stocks that the play does not offer. This makes it possible to keep retirement savings in one tax-deferred account even while benefiting from the ESG growth.

Yes, there is indeed some drudge work involved in formulating the right ESG stock mix. But, remember, it will still be rewarding work.

Source WSJ

Picture credit: Greenlink

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