Making an Impact: SDGs and ESG
Gavin Smith, Head of Equity Research and Sustainable Investing at PGIM Quantitative Solutions, argues a balance can be struck between investing in line with values and financial performance.
Financial returns have always been the primary objective for institutional investors. Increasingly, however, they are also rightfully considering the means by which these returns are generated, expressing concerns about investing in companies that don’t align with their values. The challenge herein lies in balancing value-based investing ideals with achieving positive returns. This article explores how institutional investors can have their cake and eat it too by investing in line with their values and simultaneously outperforming the benchmark.
Hurdles to ESG investing
It’s common knowledge that evaluating the impact of public companies has been difficult due to limited reported data. Compounding this issue, certain companies use deceptive marketing practices to mislead investors into believing their products, services, and policies align with ESG values. This practice, known as greenwashing, has undoubtedly damaged ESG’s reputation.
This, along with the anti-ESG movement we’re seeing in some parts of the US, has left some investors starting to view ESG investing with cynicism and finding it increasingly challenging to invest for impact while maintaining positive returns.
There isn’t a sole solution
Despite these challenges, asset owners today have the remarkable opportunity to “do well by doing good” by expanding their investment goals beyond risks and returns to include approaches that address the growing social and environmental challenges worldwide. However, ESG alone is insufficient to accomplish this goal.
A clear and transparent framework is needed to help define and identify products and services that positively impact the environment and society. The UN’s 17 Sustainable Development Goals (SDGs) offer such a framework, providing investors with a straightforward method for properly evaluating companies and avoiding greenwashing.
Comparing a company’s products and services with the SDGs to assess their global impact can serve as the foundation for creating custom SDG-focused portfolios in global equity markets. However, SDGs alone also cannot provide a complete solution.
The need for SDGs and ESG
It’s important to understand the differences between the UN’s SDG measurements and assessments of material ESG risk factors. While both insights are important when evaluating a company, they are distinct.
Simply put, SDGs can measure the impact of what a company produces, while analysis of material ESG risk factors can measure how a company produces its output. This external versus internal focus is important because, while SDGs help identify companies with products that can positively impact the world and its citizens, an ESG risk focus on operational processes can identify both a company’s financial risks along with activities that could have harmful consequences for the environment and society.
Combining these insights offers a broader and more transparent view of a company’s impact, allowing investors to understand whether its operations are conducted in a clean, fair, and beneficial way. Using this two-pronged approach, companies with impactful products that are responsibly manufactured can be identified, enabling investors to build portfolios that align with both their investment- and impact-based goals.
Identifying attractive impact investments
Combining SDGs and ESG sounds great in theory, but the challenge now becomes how investors can apply this approach to identify companies with both positive impact and return potential.
The solution, as we see it, is found by following the market.
Changing consumer preferences and demand have driven companies to provide more impactful and responsible products and services, leading asset owners to increasingly seek investments that balance upside returns and sustainability. This shifting demand trend represents a tremendous secular growth opportunity for companies, underscoring not only the importance of contributing to SDGs for societal benefits, but also how it can benefit a company’s returns.
Until recently, identifying companies that made a positive impact and were also attractive investments was a burden for investors. However, by using carefully selected factors, we can assess performance potential while focusing on overall sustainability impact.
However, investors must understand two key points:
First, the trade-off between risk and sustainability requires advanced portfolio engineering. The spectrum of portfolio outcomes ranges from a simplistic (passive) portfolio with no risk exposure, but also no exposure to sustainability, all the way to a fully sustainable portfolio that is untenable from a risk perspective.
Second, and most important, customisation is essential. No two asset owners have the same perspective on which areas of sustainability to focus on, and, as such, they should not be pushed into generic strategies. The ability to customise which SDGs are targeted in a portfolio (and thereby what impact is achieved) is critical, along with considerations such as geographic regions, market cap size, and the target index.
Further, a customised portfolio might have a target on specific ESG metrics, such as low carbon emissions, while achieving alignment with SDGs. In this spirit, we have completed research where we have set a primary objective of reducing carbon emissions by 50% compared to the benchmark. This involves targeting stocks with low carbon emissions while maintaining attractive alpha attributes. Similarly, the team has also completed research into low water usage outcomes, aiming to balance sustainability with performance.
Asset owners have unique investment goals and preferences, requiring tailored solutions that can help to complete sustainability exposures across their broader equity allocations.
Ultimately, values-based investing involves sifting through a lot of noise and digesting a lot of data. But by building a customised portfolio based on ESG and SDG principles, it is most certainly possible for investors to invest with impact without sacrificing returns.
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