Let us examine the current environmental, social, and governance (ESG) situation. Climate change has begun to affect the planet negatively. The social aspects of many people require significant improvement. Additionally, the governance of many companies, organizations, and countries need to become better. And money rules the world. Investors, therefore, should try to influence the ESG aspects of the users of capital. Investors should also do this in their own monetary interests. Investing in companies, organizations, and countries with rather low ESG risks is more prudent than investing in high ESG-risk entities. This is especially true if the additional ESG risk is not compensated adequately. And this seems to be the case. On an average, more sustainable investments so far have had similar, if not better, returns than less sustainable investments. And their financial risks have been lower, rather than higher (NYU-RAM_ESG-Paper_2021.pdf). It is no wonder that sustainable investments are booming in many parts of the world.

Problems with current approaches

Unfortunately, there is no generally accepted definition of sustainable investments. But four approaches can be identified: 1) Exclusions 2) ESG ratings 3) Positive selection criteria such as alignment with the Sustainable Development Goals (SDGs) of the United Nations, and 4) voting and engagement.

Exclusions

Do we need nuclear energy because it is climate friendly, or should we exclude it from our investment portfolios because of nuclear risks? Should weapon manufacturers be excluded, or do we need weapons for defense? Are genetically modified organisms fundamentally bad or can they help to reduce hunger?  Should animal testing be banned, or is it important for medical progress? Should lotteries and gambling operators be legal because they bring in a lot of tax revenue that can be used for social purposes? Should tobacco use be allowed for tax reasons or because early mortality reduces costs of healthcare systems? And is it necessary to exclude fossil fuels because they harm the climate? It is a fact that a great many companies and individuals will continue to rely on fossil fuels for a long time to come.

ESG ratings

Typically, in addition to exclusions, relative ESG ratings are compared so that only the best securities according to such ratings may be included in a portfolio. ESG data providers sometimes record well over 100 ESG criteria per security. It is no wonder that different analysts or providers arrive at different ESG ratings for the same security. Moreover, even securities with relatively good ESG ratings can still be found to have many ESG deficiencies because poor individual scores can often be compensated for by other good scores. Tesla’s case is prominent because it was excluded from a sustainability index even though it scored well in most environmental ratings. But Tesla often does not seem to score well on social and/or governance ratings. The company also complained that an oil producing company remained in the sustainability index. But many indices want to include all major market segments. If the aggregated ESG rating of such a company is relatively good compared to its industry peers, it may stay in the (best-in-class) index. Using separate minimum requirements for E, S, and G, and following a best-in-universe rating approach can be used to create more sustainable portfolios. However, there are very few investment products available with such approaches.

Positive selection criteria

ESG ratings, therefore, typically show the relative ESG risks for investments. For demanding sustainable investors, it is more important that the products and services of investments are aligned with their values. Often, alignment with the SDGs is used to select investments. However, very few investments are well aligned with the SDGs.

Voting and engagement

Because investments are not perfect with respect to either ESG criteria or SDG alignment, investors try to improve their investments. This is much easier if they are very large and own high shares of equity or debt of the investments. Also, investors have more leverage with private investments compared to public investments because the threat to not invest or divest is bigger if there are no liquid secondary markets with other investors eager to replace them.

With equities, investors can also try to change investments by using their voting rights. With all investments, they can try to engage and enter into dialogues with the potential recipients of investments to improve them, for example, with respect to sustainable aspects. But even large investors often have limited abilities to change investments.

Some investors strategically invest in the least sustainable companies because they claim that the sustainability improvements can be especially high in such cases. But this means that they withhold their money from companies that have already become more or less sustainable. Therefore, I do not consider this investment strategy to be very sustainable.

Fintech solutions for custom ESG indexing

Investors should start with defining their own broad sustainability strategy (PRISC – Policy for Responsible Investment Scoring: This is what I expected from the EU Taxonomy Expert Group – Responsible Investment Research Blog (prof-soehnholz.com)) before they select investment products. Today, many sustainable investments are on offer. But if investors demand a high and individually fitting sustainably profile, they will typically find very few suitable products.

Customization therefore is key and financial technology (fintech) can play an important role. The easiest way to create custom solutions is to start with a transparent investment universe such as an index. A sustainable investment index that has already excluded many obvious unsustainable investments can be the starting point. Based on this index, investors can easily exclude further investments that do not fit in with their values.

Direct indexing software can help to create such individualized rules based on sustainable portfolios. If combined with efficient trading software, direct implementation of the portfolios is possible.

Charles Schwab, BlackRock, J.P. Morgan, Morgan Stanley, Goldman Sachs, Vanguard, Morningstar, and Franklin Templeton have all recently acquired companies with direct indexing capabilities. However, they are mainly used to create customized, tax-optimized portfolios and not sustainable ones. Implementation is often limited to US Large Caps or requires rather large investment amounts. Therefore, there is still room for new individualized ESG portfolio service providers. Using the most advanced software options, such portfolios can be implemented very cost effectively. For example, ALLINDEX, a Swiss fintech, offers such a solution, which is also availabe as white-label option.  Since sustainable investments are a mega trend, such individualized sustainable portfolios can become really attractive in the near future.

By Dirk Soehnholz, CEO, Soehnholz ESG GmbH, Germany