What Exactly Is ESG Investing?

Risk Management

In short, ESG investing is a quantitative method for applying responsible investing to an investment strategy.

In practice, it’s really a risk management tool that, when layered on top of fundamental investment analysis, helps identify investment opportunities better positioned to deliver positive returns.

Sustainable Investing is a long-term approach that incorporates environmental, social and governance factors into the investment process.” (Morningstar)

Three Pillars of ESG Investing

ESG investing is specifically focused on three pillars: environmental, social and governance responsibility. And within those three pillars are specifically identified issues generally agreed upon as important for society as a whole:

 

Sustainable Finance ESG Pillars

(CFA Institute)

ESG Investing Strategies

Sustainable investing is generally broken up into various activities or strategies, with ESG Integration identified as the most widely used technique by most analysts.

 

Top ESG Investing Strategy: ESG Integration

(2015 CFA Institute)

How We Use ESG Integration

Some investors want to know they are investing in companies with strong sustainable practices and ethical policies. It’s a way of aligning their investments with their values. Others see ESG as a set of factors often overlooked in traditional analysis that should be incorporated for a more complete assessment of an investment.” (Morningstar)

ESG Integration & Equity Valuation

At Pathview & Associates we use ESG Integration for the systematic and explicit inclusion of Environmental, Social, and Governance risks and opportunities in investment analysis. This integration is applied at the very core of equity valuation via the discounted cash flow method (DCF)A valuation method used to estimate the attractiveness of an investment opportunity.

There are two ways ESG information becomes integrated into our DCF model:

  • Discount Rate: Companies that score poorly on ESG metrics will have a higher risk profile on average; thus, a higher discount rate (and lower valuation) in the DCF.
  • Future Cash Flow Estimates:  A company’s ESG profile can indicate reasonable cash flow estimate modifications. Adjusting future cash flows allows for more transparency and leeway when preparing a DCF model.

Mutual Funds Over Individual Stock Investments

Investing in mutual funds provides protection for your assets by minimizing risk through diversification. Rather than putting your money into a single company, mutual funds contain many different securities, allowing for a more diverse set of options.

ESG-focused mutual funds

Funds with ESG or values-based mandates are the traditional tool available for investing in the ESG space with mutual funds. These funds have ESG guidelines that managers must adhere to. Additionally, both Morningstar & MSCI (Morgan Stanley Capital International) have developed systems to rate mutual funds on an ESG-basis, making it easier to find and compare ESG-positive funds.

In simple terms, sustainability ratings work by aggregating the sustainability profile of the fund’s holdings and giving the fund a weighted average rating.

ESG ratings not only increase the transparency of ESG-mandated funds, but they also give investors more options when looking for ESG-positive rated funds. Rather than having to pick solely from mutual funds with ESG-mandates, an investor can now sort and screen funds by ESG rating and pick those with the best profiles.

At Pathview & Associates we believe in having a long-term investment approach, and that asset allocation and portfolio diversification are crucial for helping you reach your goals and live the future of your dreams.

THE POSSIBILITIES ARE ENDLESS.

Let Pathview & Associates help you with your ESG analysis to create a financial plan for a sustainable investment strategy.

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