By Karalyn Carlton April 30, 2018

There is no doubt that sustainable investing is rapidly becoming part of the global investment mainstream.

As of September 2016, 1,055 asset managers had signed the UN-backed Principles for Responsible Investment, committing themselves to incorporating sustainability issues into their investment processes1.

Many studies have taken place on the merits of sustainable investing. However before I go farther, an introduction of what 'SRI' and "ESG' mean and how the terms evolved is warranted.

The first exclusionary fund began in 1971 and excluded alcohol, tobacco, and gaming stocks. New funds were launched in the 1980s to exclude these and other companies, such as those companies that did business in South Africa. The term, Socially Responsible Investing was coined. Over the last twenty years, however, the notion of what was "socially responsible" came under debate. Was avoiding alcohol more socially responsible than avoiding companies that polluted the environment, didn't promote women or minorities, or engaged in economically predatory behavior? In addition, some argued that the best way to improve corporate behavior was not to exclude these companies from portfolios but to become shareholders and change company policy through dialogue and proxy contests. Ultimately, two different types of investing emerged in this area.

The first type, "Socially Responsible Investing" or "SRI" is about aligning investments with the values of the SRI investor by excluding securities due to their exposure to products or services that are deemed inconsistent with the values of the SRI investor . Often these exclusions are referred to as "sin stocks" - tobacco, alcohol, pornography, and gambling, but they can also include things like fossil fuel use or diversity on the board or directors.

The second type, which specifically addresses the various environmental, social, and governance, or "ESG," issues began when researchers began collecting and analyzing ESG data on companies. Companies that do well on ESG evaluations are often referred to as "sustainable" firms. Funds with an ESG mandate overweight exposure to companies that score highly on ESG metrics and underweight those that score poorly. Hoping to have a dialogue with poor scoring companies, they do not exclude these companies from portfolios.

Simply put, SRI investing avoids or excludes certain investments, while ESG is about the inclusion and selection of companies that score well on sustainable issues.

One of the biggest obstacles to sustainable investing is the perception that it has a negative effect on investment performance.2

Statman and Glushkov studied the effects of both SRI exclusion and ESG inclusion. Analyzing stock returns from 1992 through 2007, the authors found that tilting a portfolio toward stocks with best-in-sector ESG characteristics provided an advantage over conventional portfolios. Portfolios focused on shunning stocks associated with tobacco, alcohol, gambling, firearms, military, or nuclear power resulted in a disadvantage relative to conventional portfolios. 3

This long-term study mirrors what much of the academic research suggests: When an investor only excludes investments, the portfolio is more likely to underperform. However, the data suggests that firms effectively addressing the key ESG risks and opportunities faced in their businesses tend to be stronger financial performers over the long run.

In addition, the 2007 joint report authored by Mercer and the UNEP Finance Initiative summarized 20 academic studies, concluding: "While the results vary depending on the factor being studied, the region and the sample period, the evidence suggests that there does not appear to be a performance penalty from taking ESG factors into account in the portfolio management process. "4

A 2015 report from Arabesque Partners and Oxford University reviewed more than 200 studies on the relationship between corporate sustainability practices and financial performance. More than 80 percent of the studies reviewed indicated a connection between better company sustainability practices and lower cost of capital, better operational performance, and better stock-price returns. 5

Studies have shown that companies with superior overall sustainability performance have better credit ratings; 6 that firms with environmental management systems have lower credit spreads; and firms with significant environmental challenges have higher credit spreads. 7

Companies that have demonstrated they handle environmental issues better than their peers have also shown significantly lower cost of equity.

Stay tuned. In my next piece, I'll delve further into who is driving the growth of sustainable investments.

If you or someone you know are interested in learning more sustainable investment management, please contact me at 1-206-745-5505.

1 Signatory Directory, accessed Oct. 30, 2016, http://www.unpri.org/directory.html

2 "Gateways to Impact: Industry Survey of Financial Advisors on Sustainable and Impact Investing," June 2012, P. 5; CFA Institute. 2015. Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals, P. 12; Ignites. 2016. "Poll: What's the Biggest Hurdle to Adoption of Socially Conscious Funds?" Sept. 27, 2016

3 Statman, M. and Glushkov, D. 2009. "The Wages of Social Responsibility," Financial Analysts Journal, Vol. 65, No. 4, P. 33-46.

4 UNEP Finance Initiative and Mercer. 2007. Demystifying Responsible Investment Performance: A Review of Key Academic and Broker Research on ESG Factors. P. 36.

5 Arabesque Partners and University of Oxford, 2015. From The Stockholder To The Stakeholder: How Sustainability Can Drive Financial Performance, Updated Version, March.

6 Attig, N., et al. 2013. "Corporate Social Responsibility and Credit Ratings."
Journal of Business Ethics, Vol. 117, P. 679-694.

7 Bauer, R. and Hann, D. 2010. "Corporate Environmental Management and Credit Risk." Maastricht University ECCE Working Paper; Chava, S. 2014. "Environmental Externalities and Cost of Capital." Management Science, Vol. 60, No. 9, P. 2223-2247; Goss, A. and Roberts, G.S. 2011. "The Impact of Corporate Social Responsibility on the Cost of Bank Loans."

Journal of Banking and Finance, Vol. 35, P. 1794-1810