Most of the time, we think about our investments in pretty simple risk/return terms, and generally in reference to some benchmark.
Treasuries? Lower risk, lower potential return than stocks.
Emerging markets? Higher risk, higher potential return than the S&P 500.
Even if we don’t label everything in the style box with risk and return, the growth/value and small/large cap axes we’re used to seeing from our friends at Morningstar carry with them a clear assumption: Small-cap growth is probably riskier, and has a bigger potential, than large-cap value.
But when you get to environmental, social and governance (ESG) investing, things get a lot more complicated. All of these risk/reward issues—capitalization, industry concentration, growth/value, beta—still matter. But now you have to consider the “ESG-ness” of your strategy.
Next week I’m hosting a webinar with Richard Cea from InsightShares, and one of the slides he submitted highlights this beautifully:
Broad & Narrows Focuses
The idea above is actually pretty simple: At the core, every ESG idea either has a broad market approach, or naturally narrows in on particular geographies or industries. A clean energy fund, for instance, is going to be light on fossil fuel stocks.
Each strategy also makes certain choices about how pure it’s going to be—are securities “in or out”? Or are there just shades of relative gray, tilting the fund in a certain direction?
Where a given ESG strategy falls on these axes has implications for risk and return—the most absolute, sector-specific strategies can be undiversified, and thus riskier—but also have real implications for how “pure” a given approach is.
Understanding what you want out of your ESG investment on these two axes is critical, but perhaps nowhere more so then when we think about the “S” in ESG.