Responsible investing is an investment approach that combines environmental, social and governance (ESG) criteria with traditional financial research.
Although this approach to investing goes back decadesSource: Report on Responsible Investment, The Investment Funds Institute of Canada, 2020, it has seen an explosion of interest in Canada in recent years. ESG criteria can be incorporated into virtually all types of investments, including mutual fundsA mutual fund is made up of money that is pooled by several investors and used on their behalf by a manager to buy shares, bonds or other securities in line with the fund’s objectives. , exchange-traded funds (ETFs)An exchange-traded fund (ETF) is an investment fund whose securities are traded on an exchange like shares.
These funds generally track a benchmark index. Unlike a mutual fund manager, an ETF manager does not seek to maximize the fund’s return but only to follow an index; this explains the typically lower management fees for ETFs. , stocksA share, also referred to as stock, is an equity security that entitles you to an ownership interest in a company.
The company can distribute a portion of its earnings to shareholders by paying them a dividend.
The shares of companies listed on an exchange are bought and sold at the exchange.
When a company ceases to operate, the proceeds from the sale of its assets are used to pay its debts and taxes, and the rest of the money is distributed to shareholders. and bondsA bond is a security issued by governments and companies through which an investor lends money to the issuer.
In general, the government or company promises to pay the investor interest at a fixed rate and at certain intervals (for example, 2% per year). Interest is normally paid twice a year. At maturity, the government or company pays back a predetermined amount that is called the face value. The face value is usually $1,000.
There are several types of bonds:
Stripped bondReal return bondConvertible bondSavings bondRetractable bondUnsecured bondEtc. .
Generally used ESG selection criteria
There are no specific regulations currently governing responsible investing in North America and no consensus on how responsible investing should be defined. Individuals and firms that offer responsible or sustainable investment products can therefore apply their own selection rules. This may lead to confusion as to whether an investment is truly responsible or not.
However, recognized criteria generally fall under the three dimensions discussed above. You should therefore carefully review the criteria used to make sure they are aligned with your investment objectives and values. Here are some common examples of ESG factors:
Protects the environment
- Protects biodiversity
- Uses clean energy
- Mitigates climate change
- Limits greenhouse gas emissions
- Conserves water
- Reduces pollution
- Limits the amount of waste it produces
- Uses natural resources while restoring them, if possible, to their original condition
- Does not contribute to rising sea levels
Treats employees, customers and the general public properly
- Respects local communities
- Offers fair working conditions
- Does not use child labour
- Ensures gender equity
- Treats minorities fairly
- Partners with charitable organizations
- Provides a safe workplace
- Respects human rights
- Does not manufacture offensive weapons or tobacco products
Applies good governance practices
- Fosters board independence from senior management
- Does not pay executives excessive compensation
- Adopts anti-corruption policies
- Adopts ethical behaviour
- Promotes a culture of compliance
- Implements transparent accounting practices in accordance with standards
- Pays its fair share of income tax
- Properly manages lobbying activities
- Fosters a culture of diversity among its executive officers and board members
You can refer to these criteria to pursue one or both of the following goals:
- To choose investments that seem to offer a higher potential return or lower risk as a result of ESG factors
- To generate a positive environmental, social and corporate governance impact
The challenges of investing while taking ESG criteria into account
Companies have different ways of assessing compliance with ESG criteria, potentially making it difficult to compare ESG performance across companies or ESG investment funds. However, there are international organizations that assess the sustainability of companies on the basis of their environmental, social and governance performance. You therefore need to do your homework before investing.
The information disclosed by companies is not always optimal. For instance, managers of ESG investment funds may sometimes include companies with weak ESG disclosure in their investment fund portfolios.
The selection criteria performance of an ESG investment fund can be misleading to investors if the fund considers only one of the three investment criteria (“E”, “S” or “G”). For example, an ESG investment fund may be strong on governance but weak on the environment. When doing your homework, find out how the portfolio manager picks securities. That way you will know whether the manager’s decisions are based on just one selection criterion.