Responsible Investing (RI), while sometimes viewed as a relatively recent phenomena, is the evolution of an investment philosophy that has been around for quite a while. However, it is only in the last few years that RI has gone from being a niche market to having widespread understanding and acceptance. Twenty years ago, if you had walked into your advisor’s office and asked them about Responsible Investing (or ethical investing, which was kind of like the beta version of RI), they probably would have looked at you blankly before asking how much Nortel you wanted to buy. These days, most Advisors have at least heard of Responsible Investing, and many of the best in the field have already incorporated it into their practice.

 

At its most basic, Responsible Investing is another risk management tool in the investor’s toolkit. It is the idea that looking at a company from a strictly financial perspective does not tell you the whole story. While balance sheets and financial reports are still very important in analyzing a company’s business, non-financial risks such as environmental impact, employment conditions and corporate governance concerns, among many others, must also be taken into account. These factors are collectively known as ESG (Environmental, Social and Governance) factors and most, if not all, RI strategies include some degree of ESG analysis.

 

Deepwater Horizon Case Study

 

A good example of the benefits of ESG analysis can be found in the Deepwater Horizon oil rig explosion. In 2010 Deepwater Horizon, a drilling platform operated by British Petroleum (BP) in the Gulf of Mexico, exploded, releasing millions of barrels of oil into the ocean and killing 11 workers. While this was first and foremost a human tragedy, there was a significant impact on BP’s share price. The shares sank 55% following the explosion and have never since reached the levels they were at in April 2010 (to be fair, as we noted in a recent blog post, energy has had its share of challenges over the past decade and BP’s share price reflects this reality).

 

Leading up to the explosion BP was considered one of the leaders in the energy industry, even though it had received over 760 safety violations in the three years preceding the disaster. To put that in perspective, the next worst offenders were Sunoco and Conoco-Phillips with eight violations apiece. While information on these violations was available, it did not show up in financial statements. To see the warning signs, one would have had to have been using an ESG filter as well as traditional financial analysis. This is precisely what MSCI, a leading provider of ESG focused indices, did. In the months prior to the explosion, MSCI had seen the violations and removed BP from its ESG Leaders index. As a result, investors who followed that index managed to avoid the declines experienced by BP shareholders.

 

But Does It Make Money?

 

The BP story is just one of many examples of ESG analysis helping investors reduce portfolio risk. However, reducing risk is just one (important) component of portfolio management. It doesn’t help to have a risk managed portfolio if it isn’t generating overall returns. For many years, those advisors who were aware of concepts like Ethical or Responsible Investing tended to dismiss them. The question that was often asked of interest clients was something along the lines of “don’t you want your portfolio to make money?”. The implication, of course, was that generating strong returns and investing responsibly were mutually exclusive. Over the past few years, there has been a growing body of research that has shown the opposite to be true. Companies that screen well on ESG metrics also tend to outperform their peers in the long run. It makes sense. A company that pays attention to these factors likely has a greater understanding of its overall corporate structure and footprint, allowing it to operate more efficiently and profitably.

 

We are always happy to talk about RI strategies. We can provide interested clients with RI focused portfolios and in general our investment process incorporates ESG factor analysis. Let us know if you have any questions about this space, or if you would like to have your current portfolio reviewed from an ESG perspective.

 

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