This Sunday is Earth Day.
These days, environmental causes have become polarizing issues that are frequently exploited and oversimplified to win political points. While we may not all agree as to what problems should be the highest priorities, we virtually all prefer that our air and water be clean and that animals like rhinos, whooping cranes, and even blind salamanders are around for our grandkids to see. We also generally agree that making money is a good thing.
Earth Day was first observed in 1970, also the year that saw the creation of the US Environmental Protection Agency, and the passage of the Clean Air, Clean Water, and Endangered Species Acts.[1] What may be most surprising to many is that these pieces of legislation were not always as divisive as they appear today. For example, the Clean Air Act passed the Senate without a single nay vote, and while the Democrats controlled both houses, the President that signed the bills into law was a Republican.
As citizens, we certainly can express our political preferences around sustainability through the ballot box. But growing interest in our impact on the planet increasingly sparks questions about whether investors can integrate their values around sustainability with their investment goals and, if so, how?
One key question we face is how to do this without compromising our desired investment outcomes. For instance, how can we reduce our portfolio’s environmental footprint while maintaining sound investment principles and achieving our investment objectives?
Sustainability preferences can include greenhouse gas emissions, land use and biodiversity, toxic spills and releases, operational waste, water management, and other issues. Thus, it is a challenge to achieve the dual goal of efficiently considering sustainability preferences while building investment solutions that help meet investors’ financial goals. One way to approach this challenge is to focus first on developing an investment methodology that emphasizes what research indicates are reliable sources of higher expected returns while also aiming to minimize unnecessary turnover and trading costs. For instance, this may mean starting with a broad universe of stocks ranging from very large companies to very small companies, and then systematically pursuing higher expected returns by increasing the weights of those securities with smaller market capitalizations, lower relative prices, and higher profitability.[2]
Next, investors can evaluate those companies being considered for investment using a focused set of environmental issues that reflect their primary concerns. By using a holistic scoring system, rather than a completely binary “in” or “out” screening process, investors may be able to preserve diversification while recognizing those companies with positive environmental profiles. This involves looking at companies across the entirety of a portfolio and within individual sectors with the goal of incorporating sustainability preferences while also maintaining the characteristics of the original strategy. For example, if one is trying to reduce a portfolio’s greenhouse gas emissions and potential emissions from fossil fuel reserves, the worst offenders across all industries may first be deemphasized or excluded from the portfolio altogether. An across-industry comparison of this nature provides an efficient way to significantly reduce the aggregate greenhouse gas emissions per unit of revenue produced by companies within a portfolio with a minimal reduction in diversification. Next, companies may also be rated on sustainability considerations within each industry. This added level of scrutiny is recognition that, in the real economy, capital markets and the supply chain are highly interconnected. For example, a retail company may consume electricity from a utility company and transportation services from a trucking company, both of which are consumers of fuel from an energy company. Comparing companies within sectors recognizes this interconnectedness and can be used to overweight the most sustainable companies within a given industry. This could include retail companies that improve the energy efficiency of their facilities, utilities that produce electricity using solar or wind power, trucking companies that improve the fuel efficiency of their fleets or use alternative-fuel vehicles, or energy companies that increase efficiency, reduce waste, and improve their overall environmental footprint. On the other hand, companies with poor environmental sustainability ratings relative to industry peers may receive a lesser weight or may be excluded.
A Suggested Approach to Sustainability Investing
Using such a combination of company selection and weighting may allow for substantial reduction in exposure to greenhouse gas emissions and potential emissions from fossil fuel reserves—important goals for many investors—while providing a robust investment strategy that is broadly diversified and focused on the drivers of expected returns.
The key takeaway for investors is that investing well and incorporating values around sustainability need not be mutually exclusive. By starting with a robust investment framework, then overlaying the considerations that represent the views of sustainability-minded investors, this allows for a cost-effective approach that provides investors the ability to pursue their sustainability goals without compromising on sound investment principles or accepting lower expected returns.
If you have questions about how to make your portfolio more sustainable, both environmentally and return wise, get in touch.
(Adapted from the DFA April 2018 Issue Brief)
[1]. https://www.earthday.org/about/the-history-of-earth-day/
[2]. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book equity.
Source: Dimensional Fund Advisors LP.
Diversification does not eliminate the risk of market loss. There is no guarantee an investing strategy will be successful. Investment risks include loss of principal and fluctuating value. Sector-specific investments can also increase these risks. Environmental and social screens may limit investment opportunities.
Small and micro cap securities are subject to greater volatility than those in other asset categories.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.