Three Pillars of Modern Responsible Investment

Abstract

Modern responsible investment encompasses three distinct activities: alignment of portfolios with client values, using exclusions; integration of environmental, social, and governance (ESG) factors into the investment process, often with a focus on financial materiality; and impact, which in public markets is usually sought through engagement with corporate management. All three fields are progressing rapidly, and each has a distinctive set of professional practices and supporting empirical literature: The performance effects of typical exclusion policies apparently remain benign, but recent research suggests that information about ESG performance may have important implications for portfolio risk. The emerging evidence on engagement is potentially disruptive, with a small but strong group of papers suggesting that it can positively affect financial and stock market performance, as well as the investment behavior of corporate managers. With new practices and findings emerging in each of these areas, investment professionals will be challenged to keep up with the pace of innovation and, in an increasingly competitive marketplace, to implement these policies at a high standard.

TOPICS: ESG investing, portfolio theory, portfolio construction

Key Findings

• • The field of responsible investment is complex, and modern practice requires that practitioners develop facility in three distinct but related areas, each with its own goals, practices, and empirical literature. This article addresses recent research in these areas, and finds strong empirical support for some practices.

• • The field of EGS integration is becoming more standardized with the advent of disclosure such as those published by the Sustainability Accounting Standards Board. Many studies document an association between ESG performance and traditional ideas of firm quality, and a few good papers have documented instances where ESG factors were associated with strong investment performance. But many studies have significant methodological shortcomings. With ESG practices becoming more widespread it is not realistic to expect significant performance benefits from typical ESG integration practices.

• • The UNPRI active ownership mandate has led to a significant increase in corporate engagement efforts. A small but strong group of papers suggests that, when successful, these initiatives have positive impacts on near-term stock price performance of targeted companies, as well as subsequent corporate investment behavior.