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Sustainable Investing

Integrating Environmental, Social and Governance (ESG) Criteria Into an Investment Process

Sustainable Investing is undergoing a transition from niche strategy to mainstream. For most of the 20th century, investors only had access to the exclusionary strategies associated with SRI. A counterintuitive approach and lack of clear performance benefits left many cynical about the benefits of such strategies. However, the early 2000s saw the arrival of Sustainable Investing, with its inclusive approach that integrated assessment of a company’s ESG characteristics with rigorous financial analysis.

The key to understanding Sustainable Investing today is to appreciate how it has evolved from its origins. Rather than maintaining the solely exclusionary processes of past iterations, Sustainable Investing strategies invest using an integrated approach that combines bottom-up analysis of both the financial and Environmental, Social and Governance (ESG) characteristics of a company. These Sustainable Investing strategies are inherently actively managed. The potential benefits of including ESG characteristics are grounded in intuition and supported by academic research.

With greater recognition of the benefits of Sustainable Investing, investors are showing increased interest in it. As asset managers work to meet this burgeoning demand, the number of strategies being offered in the marketplace is also growing. Given the relative nascence of the topic, a confusing overlap of terminologies and a rapid build-out in the product set, Sustainable Investing can present unique challenges from an investment due diligence perspective. Despite these hurdles, more investors are beginning to recognize the opportunity it may present.

Sustainable Investing In-Depth

Assessing Actively Managed Sustainable Investing Strategies

Given the burgeoning interest in this relatively nascent space, many investors are analyzing Sustainable Investing strategies for the first time. Like the assessment of any other investment strategy, the vetting process should focus on understanding what resources are available to support the strategy and how the Sustainable Investing discipline is defined and implemented in the context of an overall investment philosophy. Key considerations include:

  • Does the strategy utilize exclusionary screens or fundamental analysis of ESG characteristics? 
  • What ESG characteristics are considered and how are they assessed?
  • How does the discipline integrate sustainability analysis with traditional financial analysis?
  • What is the quality and extent of resources dedicated to sustainability analysis?
  • What is the manager’s experience in implementing a Sustainable Investing strategy?
  • How does the asset manager engage with company management and drive improvement in a company’s ESG characteristics?

A Modern Investment Discipline – Sustainable Investing Utilizing ESG Considerations

Consistent with the increased interest in utilizing ESG criteria, the industry underwent a change in focus during the early 2000s: exclusionary SRI gave way to Sustainable Investing,1  which is an integrated investment process that utilizes rigorous financial analysis and idea generation combined with a thorough assessment of ESG considerations. Like any investment discipline, Sustainable Investing is informed by a point of view that ESG characteristics can be used to evaluate what contributes to and detracts from investment performance over time. Similar to the perspective of a value-oriented investor who believes that low price/earnings ratios are critical to identifying attractive stocks, sustainable investors believe that strong ESG characteristics may improve a company’s operational and financial results.

The Old Regime – A Brief History of Ethical and Moral Investment Processes

The roots of ethical investing, which is the practice of excluding certain investments on religious or moral grounds, date back hundreds of years. In fact, in colonial America some religious groups avoided investing their endowments in institutions that supported the slave trade1. Similar investment practices continued through the 20th century, as some investors avoided investment in alcohol, tobacco and gambling due to religious or moral objections. As religious and moral considerations were specific to each investor, ethical investing was a highly customized investment practice.

The first step in bringing these types of strategies to a broader investor base came in 1971 with the launch of the first ethically responsible mutual fund. The timing was not accidental. At the height of the Vietnam War and the beginning of the environmental movement, interest in ethical avoidance gained relevance beyond religious considerations. During the 1970s, Socially Responsible Investing (SRI) began to take hold as a stand-alone investment concept based on ethical and moral exclusions and subsequently became a catch-all term to describe any investment process using exclusionary screens based on religious, environmental and ethical beliefs4. From the 1970s through the 1990s, SRI strategies experienced some success in gathering assets. By the mid-1990s there were about 60 distinct SRI mutual funds that managed around $640 billion5. However, the perception of SRI quickly focused on its exclusionary practices. It was widely debated whether the blanket exclusion of sectors or industries led to lower returns. As a result, SRI strategies gained limited appeal among investment professionals due to the perspective that investment performance would be hampered.

A Note on Terminology and Definitions

The range of terms used to describe strategies that focus on some form of values and sustainability integration can be bewildering at times. Terminology and definitions often vary slightly depending on the source or speaker. For consistency in this paper, the following definitions will be used:

  • Ethical Investing2 – Investment philosophy guided by morals, ethics or religious beliefs in which investment decisions include non-economic criteria. The practice is traditionally associated with exclusionary screening.
  • Socially Responsible Investing (SRI)2 - Similar to ethical investing in that it may involve trade-offs between social and financial performance. Seeks to minimize negative social impact by predominantly using exclusionary screens.
  • Impact Investing3 – Discipline that combines consideration of financial performance with social and environmental performance. Distinguished from SRI by allocating capital and engaging company management to actively produce positive social impact.
  • Environmental, Social and Corporate Governance (ESG) criteria2 – A variety of issues that investors consider in the context of corporate behavior. Though no definitive list of ESG issues exists, they often include issues that have traditionally been considered non-financial and have a focus on a changing regulatory environment, the public-concern or supply-chain management.
  • Sustainable Investing – The integration of ESG considerations into the investment management process with the objective of creating positive financial impact for investors.

The Evolution of ESG Standards

In the early 2000s, however, investors began to acknowledge that certain environmental, social and governance (ESG) issues that were typically not included in traditional financial analysis materially affected corporate performance and, ultimately, returns to investors. In an effort to formalize certain ESG standards and goals, the United Nations introduced the Principles for Responsible Investing (PRI) in April 2006. PRI is a voluntary initiative in which signatories agree to incorporate six principles into their investment processes6.

Signatories commit to:

  • Incorporating ESG issues into investment analysis and decision-making processes.
  • Being active owners and incorporating ESG issues into ownership policies and practices.
  • Seeking appropriate disclosure on ESG issues by the entities in which they invest.
  • Promoting acceptance and implementation of the principles within the investment industry.
  • Working together to enhance effectiveness in implementing the principles.
  • Reporting on activities and progress toward implementing the principles.

Additionally, signatories publicly assert their adherence to these six principles through the United Nations’ PRI list of signatories.

There is a growing view among investment professionals that ESG issues can affect the performance of investment portfolios. Investors fulfilling their fiduciary (or equivalent) duty therefore need to give appropriate consideration to these issues.
UN Principles for Responsible Investment
As of March 31, 2018, there were over 1,950 signatories with over $81 trillion in assets under management. Signatories included asset owners, investment managers and service providers7.

 

While there is no definitive list of ESG criteria that a signatory must evaluate, some example considerations are detailed below:

  Sample Issue Potential Impact
"E" Environmental  Environmental Disclosure & Transparency
Energy Efficiency
Waste Management
Lower Regulatory & Reputational Risk
Save on Energy Costs
Reduce Environmental Liabilities
 "S" Social Diversity, Labor and Human Rights Issues
Product Safety & Quality
Community Relations and Philanthropy
Mitigate Litigation Risk
Create Brand Loyalty
Protect Standing in Communities
 "G" Goverance Transparent Financial Disclosure
Reasonable Executive Compensation
Employee Satisfaction
Improve Shareholder Relations
Lessen Headline Risk
Dampen Turnover of Personnel

Explore Touchstone's Actively Managed Sustainable Investing Funds

Touchstone Investments has funds sub-advised by firms whose strategies incorporate ESG factors throughout their processes, who recognize that certain ESG issues that were typically not included in traditional financial analysis materially affected corporate performance and, ultimately, returns to investors.

Touchstone Global ESG Equity Fund

Actively Managed and Sub-Advised by Rockefeller & Co. Inc.

AN ACTIVE APPROACH TO SUSTAINABILITY
Rockefeller evaluates traditional Environmental, Social, and Governance elements, while active engagement with company management helps drive sustainability improvements at portfolio holdings.

  • Views sustainable investing as the search for solutions that could have an enduring financial value and a lasting impact
  • Fundamental financial analysis seeks to identify U.S. and non-U.S. companies which appear to have compelling valuations relative to their growth prospects over a 3-5 year horizon
  • Utilizes an investment approach that centers around 4 pillars: Governance, Products & Services, Human Capital Management and Environment
  • Believes that good governance practices and corporate responsibility may enhance investment opportunities in long-term oriented industries that exhibit attractive growth and income potential
  • Integrates financial analysis with sustainability and impact analysis in an effort to invest in companies believed to have sustainable competitive advantages
  • Seeks investment opportunities unconstrained by geography and sectors using ESG objectives and principles as a guide

Touchstone Impact Bond Fund

Actively Managed and Sub-Advised by EARNEST Partners LLC

AN ACTIVE APPROACH TO SUSTAINABILITY
EARNEST Partners believes that entities/programs that are cognizant of ESG issues tend to be more successful over time.

  • Strong and seasoned portfolio management team with a focus on ESG investing for over 20 years
  • Signatory Member of UN Principles for Responsible Investment
  • Focus is placed on high-quality securities, many with beneficial structures such as government guarantees or significant tangible collateral support; there is limited exposure to non-investment grade securities
  • The firm’s sustainability factors support programs such as economic development and advancements in employment, affordable housing and home ownership through the Fund’s investments in small business (SBA) loans, agency, multi-family housing and municipal housing authorities
  • Utilizes a traditional long-only investment style and invests directly in cash bonds 
  • Constructs a diversified portfolio across issuer, sector and industry that strives to maximize yield while minimizing the risks inherent in fixed income investing

Consider Touchstone’s Actively Managed Funds for Your Sustainable Investing Strategies

Touchstone actively managed sustainable investing strategies seek to identify companies possessing strong or improving ESG characteristics with the belief that such characteristics may lead to positive social and financial outcomes.
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Index Descriptions
The MSCI All Country World Index measures the equity market performance of developed and emerging markets.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI.

Index performance is not indicative of fund performance. The indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Sources
1Commonfund Institute (2013). From SRI to ESG: The Changing World of Responsible Investing. Retrieved from: http://www.commonfund.org
2Mercer LLC (2007). The Language of Responsible Investment: An Industry Guide to Key Terms and Organizations.
3J.P. Morgan Global Research (2010). Impact Investments: An Emerging Asset Class. Retrieved from: http://jpmorganchase.com
4US SIF/The Forum for Sustainable and Responsible Investment (2016). Report on U.S. Sustainable Responsible and Impact Investing Trends 2016. Retrieved from: http://www.ussif.org/trends
5US Social Investment Forum (2005). (Now known as US SIF/The Forum for Sustainable and Responsible Investment). Report on Social Responsible Investment Trends in the United States.
6UN PRI (2014). Annual Report 2014. Retrieved from: http://www.unpri.org
7UN PRI (2019). About the PRI 2019. Retrieved from: http://www.unpri.org/pri/about-the-pri
8KPMG (2017). The Road Ahead, The KPMG Survey of Corporate Responsibility Reporting 2017. Retrieved from: https://home.kpmg.com
9US SIF/The Forum for Sustainable and Responsible Investment (2018). Report on U.S. Sustainable Responsible and Impact Investing Trends 2018. Retrieved from: http://www.ussif.org/trends
10Deutsche Bank Group (2012). Sustainable Investing: Establishing Long-Term Value and Performance.
11The MSCI ACWI ESG Index is a capitalization weighted index that includes companies with high ESG ratings relative to their sector peers. The Index targets sector exposure similar to its parent index (MSCI ACWI) by including those companies with the highest ESG ratings that make up 50% of the adjusted market capitalization in each sector of the parent index. The MSCI ACWI ESG Index consists of large and mid-cap companies across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. ESG ratings are based on data from MSCI ESG Research, a team of 130 dedicated research analysts that assess a company based on a variety of ESG indicators including Governance, Human Rights, Supply Chain Management and Environment.
12Morgan Stanley Institute for Sustainable Investing (2015). Sustainable Signals: The Individual Investor Perspective. Retrieved from: http://www.morganstanley.com


Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.

Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in a fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.


Please consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial advisor or download and/or request one at TouchstoneInvestments.com/resources or call Touchstone at 800.638.8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA and SIPC
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value