Purposeful investing in 2021

Patricia Foster, BridgeTower Media Newswires

As we begin 2021, the effects of coronavirus, which resulted in both a public health crisis and an economic crisis, continue. Although the coronavirus relief package and the development of several effective vaccines are positive developments, delivery of the vaccines has not met Operation Warp Speed targets. Against this backdrop of economic and social uncertainty we consider, in our first column of the year, an investment trend that has gained considerable traction in recent decades - "sustainable investing."

Once considered a niche investment style, sustainable investing has gained new momentum in the midst of a pandemic that has brought forth a host of difficult economic and social issues. Assets allocated to "sustainable" investments continued at record levels last year. Many investment professionals and investors believe that sustainable investing can produce investment returns as effectively as more traditional investment approaches while providing an opportunity for investors to have a positive impact on many issues that remain unsolved by government and philanthropy.


Sustainable investing and the ESG factors

Sustainable investing is a values-based investment approach that assesses the potential of a particular investment, taking into account not only the traditional risk/return analysis but also the values of the investor. This approach is also referred to as "ESG investing" because the investment process involves a consideration of environmental, social and governance factors (ESG factors) in addition to the fundamental analysis performed on every investment. In this fashion, ESG factors are integrated into the investment process with the goal of constructing a "sustainable" portfolio that does not compromise investment returns while also potentially reducing risk.


Evolution of values-based investing

We interviewed Haleh Moddasser, managing partner and senior advisor at Stearns Financial Group in Chapel Hill, N.C., to get her take on the significance of the trend toward values-based investing in general and sustainable investing in particular. Moddasser was recently named by Investment News as one of 20 "Women to Watch" in the investment management industry. She is also the author of "Women on Top: Women, Wealth and Social Change," published last year, and "Gray Divorce: Silver Linings: A Woman's Guide to Divorce After 50."

Moddasser explained that one approach to values-based investing that has been employed by investment managers over the years is "socially responsible investing" in which an investment portfolio is constructed to screen out or eliminate companies whose activities are contrary to the values of the investor. In this scenario, the investment manager allows the client to place reasonable restrictions on the management of the account. For example, an investor may not want to support companies that promote so-called "sin stocks" like tobacco and alcohol. Moddasser explained that a major drawback to the application of a negative or exclusionary screen in constructing a portfolio is that entire sectors of the market may be eliminated or over-concentrated depending on an investor's values. Consequentially, portfolio diversification may be compromised, potentially resulting in lower returns with higher risk.

Moddasser added that while sustainable or ESG investing builds on the concept of socially responsible investing, it also recognizes that ESG attributes of companies can have both positive and negative impacts on investment returns. She explained that ESG investing seeks to build a values-based portfolio by including companies that reflect the values of the investor. Under this approach, an investment manager would begin with a carefully constructed portfolio designed to take into account not only the client's risk tolerance and investment objectives, but also the environmental, social and governance policies of the companies to be included in the portfolio.

"The goal is to construct a diversified portfolio that performs like a non-ESG portfolio while also reflecting the values of the investor," she said.

In essence, the investment manager has a dual mandate - purposeful investing. The premise here is that individual investors and fund managers can collectively influence corporate behavior toward a more sustainable approach.


A closer look at the ESG factors

As noted above, the investment management industry has identified three non-financial factors that will be taken into account in constructing sustainable portfolios: environmental, social and governance. Individual investors and investment professionals alike are increasingly taking ESG considerations into account as part of their investment processes, expanding the criteria used when evaluating potential investment opportunities and risks associated with a particular issuer.

In "Women on Top: Women, Wealth and Social Change," Moddasser provides powerful examples of how a particular company's behavior in one or more of these areas can create reputational risk, thereby eroding shareholder value. In 2015, the U.S. Department of Environmental Protection found that Volkswagen had intentionally violated the Clean Air Act by programming its emissions control system to activate only during emissions testing. It was found that during normal driving conditions, emissions were actually 40 times the emissions found during the testing process. Volkswagen deployed this software in about 11 million cars worldwide, including 500,000 in the United States, in model years from 2009 through 2015. In January 2017, Volkswagen pleaded guilty to criminal charges, and in April 2017, a U.S. federal judge ordered Volkswagen to pay a $2.8 billion criminal fine for "rigging diesel-powered vehicles to cheat on government emissions tests." Software that had been designed to deceive consumers and regulators resulted in not only damage to the environment, but also considerable damage to the company's reputation, share price and bottom line. The case surrounding Volkswagen is not unique. Moddasser's book provides additional examples of how non-financial factors ultimately can have a significant financial impact on shareholder value.


Impact of DOL rule

As we enter 2021, it is clear that sustainable investing has become more mainstream. Despite considerable opposition from the investment management industry, the U.S. Department of Labor issued a rule during the fourth quarter of last year that, subject to certain exceptions, effectively prevents retirement plan fiduciaries from selecting investments based on non-pecuniary considerations such as ESG factors and requires them to base investment decisions on financial factors alone. Commenting on the new rule, Acting Assistant Secretary of Labor for the Employee Benefits Security Administration Jeanne Klinefelter Wilson said: "Our goal is to ensure that retirement security remains the top priority of those who manage the retirement assets that millions of Americans have worked so hard to earn. Retirement plan fiduciaries vindicate the public policy behind ERISA - and comply with the law - when they manage plan assets with a clear and determined focus on participants' financial interests in receiving secure and valuable retirement benefits. Plan fiduciaries should never sacrifice participants' interests in their benefits to promote other non-financial goals."


CFA Institute perspective

Nevertheless, the demand for investment solutions that feature ESG considerations continues to grow. Last year the CFA Institute published a 60-page white paper that considers the growing importance and materiality of ESG factors in an investment program. It also discusses challenges the investment management industry faces in addressing the current demand for products and services that feature these factors. One such challenge is the need for enhanced data analytics that could be used in the screening process. Another obstacle is the need for investment professionals who have been trained in sustainability, either academically or through previous work experience. The CFA Institute acknowledges that there is an established market for investment professionals who have the requisite expertise, but concludes that there is still a lack of talent in this space relative to the high demand for that talent.

This moment is an important one for the investment management industry. As the CFA Institute noted: "It is rare for a single topic to challenge such long-held theories and investing paradigms all at once, yet this is the challenge of sustainable investing, and it goes to the heart of the sustainability of investing."


Patricia Foster is a securities law attorney whose experience includes representation of clients in both registered and exempt securities offerings, as well as in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.

Published: Fri, Jan 15, 2021