Paula Fuchsberg: Investors around the world have shown increasing interest in environmental, social, and governance issues, better known as ESG. But the wide range of acronyms, terminology, and strategies related to ESG investing can make it challenging to determine what action, if any, an investor should take.
Hi, I’m Paula Fuchsberg, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re recording on May 15, 2019, we’ll talk about ESG investing—what it means, why it matters, ways to approach it, and a framework for making informed decisions.
Joining me is Drew Schneider, an equity product manager in Vanguard’s Portfolio Review Department. Welcome, Drew.
Drew Schneider: Thank you, Paula.
Paula Fuchsberg: Drew, the acronym ESG encompasses all kinds of issues that investors are paying increasing attention to. Can you give me some prominent examples in each category?
Drew Schneider: Yes, certainly. There’s a multitude of issues that fall under the categories of E, S, and G. So, on the environmental side of things, that could include greenhouse gas emissions, energy and water management, and waste generation. For social issues, that could include human rights standards, customer privacy, and workplace diversity and inclusion. Governance issues oftentimes has to do with board composition, executive compensation, and shareholder voting rights.
Now, these are just a few of the many issues out there, but what’s really important as well is the materiality of those issues. And what I mean by that is this can vary from sector to sector. So environmental issues may be more important to manufacturers and energy companies and less important to banks. Now the Sustainability Accounting Standards Board has a commonly used framework, the SASB Materiality Map, that helps investors better understand what issues are most important by industry and sector.
Paula Fuchsberg: So, when we talk about ESG investing, what exactly do we mean, and what accounts for its growing adoption?
Drew Schneider: ESG investing is incorporating those environmental, social, and governance issues as part of an investment decision-making process. And we’ve seen a growing adoption in terms of client interest and media coverage as well, and also we’re starting to see some growth in terms of mutual fund and ETF assets.
I heard a quote recently that really resonated with me and really made the analogy that it’s similar to organic, pesticide-free healthy foods; this is a trend that’s not going away.
And there’s a few things that are really driving that. We’re seeing, one, that clients are looking to align their interests and values with their investments; two, you see greater or increased policy and regulatory environment, such as the U.N. PRI; and then, also, improved reporting and data transparency from companies.
Paula Fuchsberg: And by U.N. PRI, you mean the U.N. Principles for Responsible Investment, correct?
Drew Schneider: That’s correct, which Vanguard is a signatory of.
Paula Fuchsberg: Given all this growing attention, how does ESG investing fit in with the more traditional broad financial goals of trying to maximize your long-term returns and mitigate risk?
Drew Schneider: This is, obviously, the first question that investors want to ask, and what we oftentimes get, is, “How much return am I going to have to give up by investing in ESG?” And I wouldn’t say that’s necessarily the case or as binary as people make it out to be. Similar to investing in an actively managed mutual fund, there’s going to be periods where the returns are different, both positively and negatively. There’s going to be a degree of tracking error. And so it’s important for investors who choose to invest in ESG to understand what are the exposures and gaps within the vehicle that they’ve selected and how that could influence returns both positively and negatively.
Paula Fuchsberg: And is it fair to say that, increasingly, companies are coming to see that good ESG practices can also be good for their bottom line and, therefore, for investors?
Drew Schneider: It’s definitely a growing topic for companies. They’re being much more transparent in terms of their sustainability practices as well as what they’re reporting. They have more fruitful engagements with those companies as well, and see it as a competitive advantage from their reputational and capital structure.
Paula Fuchsberg: So, in terms of assessing or addressing ESG issues in a portfolio, what kinds of approaches are available?
Drew Schneider: So in 2018, Vanguard wrote a paper, ESG, SRI, and impact investing: A primer for decision-making. In that paper, we cover the four main approaches to ESG: portfolio screening, ESG integration, impact investing, and active ownership.
With portfolio screening, an investor is looking to include or exclude companies depending on their particular views. Oftentimes, a common application of this is removing companies based on their business practices. So, depending on the investor, they may want to remove companies for alcohol or tobacco or fossil fuels—those types of exclusions, among a variety out there.
With ESG integration, an investor is looking to complement traditional investment management with ESG issues, both in terms of risk and opportunities, to help improve investor outcomes.
With impact investing, they’re looking at how they can make a positive, measurable societal or environmental impact while still generating some level of return. Oftentimes, you see this occur in the private markets with, for example, green tech venture capital.
And then active ownership is really about encouraging companies or discouraging company practices via internal or external resources. So think of, for example, shareholder proposals or proxy voting or engagements with those companies.
Paula Fuchsberg: So say I’m an investor or advisor with ESG concerns. How might I go about deciding which approach I should take?
Drew Schneider: I would recommend that investors and advisors review the paper that we wrote, as we have a great decision-making framework in there. In it, you start with defining your goals. So each investor has different values that they believe in and what means most to them. So, it’s really clearly articulating what is most important.
Also in this step, investors need to think about how far down the supply chain they want to go. For example, within the oil industry, you have a multitude of players. You have exploration and production companies, refiners, storage, transportation, financial institutions, all the way down to the end user at gas stations and airlines. So it’s important to understand how far down that supply chain you want to go.
Additionally, during this step, it’s important to think about the objectives of the investor. “Are you looking to avoid certain companies, are you looking to emphasize companies with leading ESG practices, or are you even looking for companies or an approach that makes a measurable impact?”
The next step is about evaluating the options. So this is thinking about the four different approaches to ESG investing, those being portfolio screening, ESG integration, impact investing, and active ownership.
The third step is about deciding on action. So, this is actually taking what you’ve laid out in step one in terms of your goals and objectives and aligning that with the approach that you want to take. And it’s important to think through this as well, about what are the implications, both direct and indirect implications, of the approach selected. So, are there potentially reputational or regulatory or even liquidity risks that might arise from a specific approach?
And then the final step is to reassess periodically, and this is, I think, a very important step. On a set frequency, investors and advisors should be reviewing the options or decisions they’ve made, or even not made, and look at whether they’re accomplishing what they’ve set out to do. So, for example, with a screening approach, are the companies that you expect to be excluded from a portfolio in fact being excluded? Or with an impact approach, is there a measurable impact that is within your expectations?
Paula Fuchsberg: And how about Vanguard’s approach to ESG investing? How has that evolved over time?
Drew Schneider: So, Vanguard has a long history of both offering investment products as well as advocating for best governance practices on behalf of all of our shareholders. We take our investment stewardship efforts very seriously. You may hear the phrase where we believe that ESG starts with a G. And the reason we say that is because the oversight of the risks and opportunities related to ESG begin with the board of directors.
As a firm, we’re a signatory to the U.N. PRI. And in 2019, we received the U.S. Morningstar Award for exemplary stewardship. So this is, obviously, something that we take pride in being able to deliver and serve in the best interests of our investors.
On the product side, we launched our first ESG fund back in 2000, the Vanguard FTSE Social Index [Fund]. It’s an exclusionary-based approach and is, in fact, the largest ESG index fund in the U.S.
And then last year, in 2018, we launched two exclusionary ETFs, the Vanguard ESG U.S. Stock ETF and the Vanguard ESG International Stock ETF. All three of these funds that we have launched are exclusionary approaches. Where the Vanguard FTSE Social Index [Fund] focuses on large- and mid-[capitalization] companies, the two ETFs really focus on the all-cap spectrum.
And then, just this past month, we launched the Vanguard Global ESG Select Stock Fund, which is different from the others in the fact that it is actively managed, and it is also our first fund that really focuses on companies with leading ESG practices. So, the fund’s advisor, Wellington Management Company, selects 40 to 50 stocks that they believe represent both their high bar in terms of financial productivity, as well as leading ESG practices, in their pursuit of outperforming the FTSE All-World Index.
Paula Fuchsberg: This fund follows the ESG integration approach that you’ve mentioned. So that’s a change in that regard.
Drew Schneider: That’s correct. So this is our first fund that really follows an ESG integration approach. I will say, in addition to that, Wellington does take an active ownership stance where they are engaging with company management and boards of directors over the long term and voting proxies on behalf of the shareholders, because even the best companies that have leading ESG practices still have room for improvement.
Paula Fuchsberg: Drew, do you have any final takeaways for advisors and investors regarding ESG considerations?
Drew Schneider: Certainly. We do not see ESG as a trend that’s going away. It’s important for advisors when they’re working with their clients to understand their clients’ values, the different approaches available, the decision-making framework that we help outline in our paper, and then, also, the products that we at Vanguard can offer to help meet their needs.
On the investor side of things, it’s important for them to evaluate what matters most to them and understand how the different approaches that are out there in the marketplace can help them meet their needs.
Paula Fuchsberg: Thank you so much for being here, Drew. We really appreciate you sharing your insights.
Drew Schneider: Thank you for the time.
Paula Fuchsberg: And we hope you’ve enjoyed this Vanguard Investment Commentary Podcast. Be sure to check back with us each month for more insights on the markets and investing. And, remember, you can always follow us on Twitter and LinkedIn, or visit our website at any time to learn more about Vanguard’s thoughts on financial topics. Thanks for listening.
The research cited throughout this podcast is taken from the research paper ESG, SRI, and impact investing: A primer for decision-making, available at vanguard.com.
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