Your Essential Guide to Sustainable Investing: How to live your values and achieve your financial goals with ESG, SRI, and Impact Investing

Contents

About the authors

Larry Swedroe

Sam Adams

Acknowledgments

Foreword By Burton Malkiel

Introduction

The Education of a Climber

The Education of a Capitalist

No Army Is Stronger Than a Good Idea Whose Time Has Come

An Engine for Change

The Three Questions

The Journey

Chapter 1: What Is Sustainable Investing?

Three Types of Sustainable Investing

1. Socially Responsible Investing

Example: SRI Fund

2. Impact Investing

Example: Impact Investing

3. ESG

Example: ESG Investments

Summary

What’s in a Name?

Chapter 2: Methods of Sustainable Investing

1. Negative/Exclusionary Screening

2. Positive/Best-in-Class Screening

3. Norms-Based Screening

4. ESG Integration

5. Sustainable-Themed Investing

6. Impact/Community Investing

7. Corporate Engagement and Shareholder Action

Summary

Chapter 3: Who Is Investing for Sustainability?

1. Sovereign Wealth Funds

2. Pension Plans

3. College and University Endowments

4. Faith-Based Investors

5. Family Offices and Foundations

6. Financial Advisors and Wealth Managers

7. Individual Investors

8. Institutional Asset Managers

9. Investor Coalitions

Summary

Chapter 4: Exploring Motivations

The Three Returns of Sustainable Investing: Financial, Societal, and Personal

Summary

Part of the Solution

Chapter 5: The Evolution of ESG Investing

Before ESG There Was SRI

How ESG Began

ESG 1.0: The Ratings Era

ESG 2.0: Materiality to the Fore

ESG 3.0: A Peek at the Future

Summary

Chapter 6: The Performance of Sustainable Investing

Economic Theory on Taste, Risk, and Diversification

The Price of Taste for Sustainable Investment

Conflicting Forces

Development of a Socially Responsible Factor

Do Markets Efficiently Price Sustainable Risks?

The Impact of Sustainable Investing on Investment Strategies

Returns to Private Impact Investing

Summary

Chapter 7: The Impact of Sustainable Investing—How Sustainable Investors Are Changing the World

Sustainable Investing Is Making Companies Better

Corporate Sustainability, Stock Returns, and Employee Satisfaction

Momentum in ESG Ratings and Performance

The Environmental Impact of ESG Investors

The Impact of Environmental Regulation on Companies

Does Sustainable Investing Deprive Unsustainable Firms from Fresh Capital?

Do Sustainable Funds Walk the Talk?

IPO Pricing: Does Sustainability Matter?

Does Shareholder Activism Improve Companies?

Conclusion

Chapter 8: How to Invest Sustainably

Principles All Investors Should Consider

Choosing Whether to Do It Yourself or to Hire a Professional Advisor

A Framework for Selecting ESG Managers

Research Tools for Selecting ESG Managers

Summary

Conclusion

Appendix A: The History of SRI

Religious Roots and Origins of Socially Responsible Investing

Modern Era: The Rising Popularity of SRI

Summary

Appendix B: Should You Hire a Financial Advisor?

Hiring an Advisor

Appendix C: Implementation: ESG Mutual Funds, ETFs, and SMAs

Appendix D: Resource Guide

Appendix E: Fund Manager Interview Guide

Glossary

Notes

Publishing details

Praise for Your Essential Guide to Sustainable Investing

Larry Swedroe and his co-author Sam Adams provide an insightful guide for investors interested in the hottest investment today; namely sustainable investing (SI). Their book is not simply a this is a wonderful opportunity, but a sober look at the reality that the plethora of SI funds are not particularly comparable and, in fact, the rating services provide radically different ratings for the same funds. Having set the framework and following up with details on the nature and attributes of the SI market, they conclude with a comprehensive guide on How to Invest Sustainably (and the warning that it will take work). If this is an investment universe you have an interest in entering, Your Essential Guide to Sustainable Investing is indeed an essential book to own and read.

—Harold Evensky, Founder, Evensky and Katz

Sustainable investing is a complex subject. The investing industry, as it always does, has made it even more so. Here is a book that spells out what the data and peer-reviewed academic evidence tell us. The truth is, we simply don’t know whether ESG portfolios will outperform or underperform mainstream portfolios in the future. Ultimately, though, there are far more important things at stake. Adams and Swedroe have produced the go-to guide for anyone who wants to understand the issues involved.

—Robin Powell, Editor, The Evidence-Based Investor

Demand is booming for mutual funds that specialize in ethical investing—helping you put your money into companies that support the environment, workers, and society in general. But some apparently green funds are merely green-washed, only pretending to invest ethically. How can you find investments that truly reflect your principles? This excellent book will tell you. You’ll learn the nuances of social investing as well as discover your likely investment returns. Highly recommended!

—Jane Bryant Quinn, Author, How to Make Your Money Last: 
The Indispensable Retirement Guide

You may have noticed that there’s currently a lot of buzz in the investing world about ESG and SRI. If you don’t have a clue what all this buzz is about, then this book is a must-read, since Larry and Sam get down in the weeds, explaining exactly what these investing styles are and how they may or may not be right for you. This book will bring you up to speed on these latest trends and help you become a better-informed investor.

—Mel Lindauer, Co-Author, The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to Retirement Planning

Larry and Sam present a comprehensive view of today’s ESG investing landscape. Both have a vast experience in investments and client interactions. Larry has been a prolific writer on financial topics and Sam has been a globe-trotting champion for the environment. Together they bring clarity to an evolving investment world full of acronyms, making it accessible to all interested investors.

—Eduardo Repetto, CIO, Avantis Investors

Sustainable investing is paramount for values-driven investors; yet, it is neither well-understood nor easily implemented by many investment professionals. Sam and Larry elucidate the dynamic landscape of sustainable investing and empirically demonstrate the impact of sustainable investing on firm 
characteristics such as cost of capital, valuations, and profitability, and on the performance of stocks and bonds. Moreover, they demonstrate that ESG investors, through their impact on asset prices, generate societal benefits by rewarding investments in green technologies and the reduction of gas emissions. Finally, Sam and Larry share robust investment principles and practical suggestions for building sustainable investment programs by clearly defining investment objectives, developing asset allocation methodologies, selecting underlying investments, and actively managing investment portfolios. This book is an essential resource for investment professionals who seek to understand sustainable investing and implement sustainable investment programs.

—Marat Molyboga, Chief Risk Officer, Director of Research at Efficient Capital Management

Adams and Swedroe have delivered a comprehensive review of the state of sustainable investing. They cut through the jargon, which is inconsistent and confusing at best, and misleading at worst, to help investors identify strategies aligned with their financial, societal, and personal goals. The book is essential reading for anyone seeking to put their money where their values are.

—Tobias Carlisle, Founder and Portfolio Manager, Acquirers Funds

An eye-opening guide to the opportunities and consequences of sustainable investing. I admire the thorough discussion of recent developments, the crisp bottom lines, and Burton Malkiel’s wise Foreword. Required reading for my Duke investment strategies course.

—Ed Tower, Emeritus Professor of Economics, Duke University

Read this book! After doing so, you’ll know more about Sustainable Investing than anyone you know, including your financial advisor. In Your Essential Guide to Sustainable Investing, Sam Adams and Larry E. Swedroe dive deeply, making sense of the subject’s academic research while explaining how capitalism, itself, doesn’t have to destroy our planet. This should be required reading for every investor and investment professional.

—Andrew Hallam, Bestselling Author, Balance: How to Invest and Spend for Happiness, Health and Wealth and Millionaire Teacher

Sam and I were together at Dimensional Fund Advisors for a number of years, so he is well aware of my role in co-founding Dimensional and my analytical data-driven view of investment management. Sam and Larry’s book reflects on the evolution of asset management and the challenges and opportunities ESG data analysis brings.

—John ‘Mac’ McQuown, Co-Founding Dimensional Director, and Co-Proprietor, Stone Edge Farm

Experienced financial practitioners are typically wise enough to approach financial product innovation with healthy skepticism. Sam and Larry cut through the noise of greenwashing and marketing jargon to offer a genuine roadmap investors can use today to achieve the long-term returns stakeholders require while effecting a sustainable positive impact on the world.

—Adam Butler, Chief Investment Officer, ReSolve Asset Management

If you really want to understand the research, risks, returns, ratings, and reasons to own ESG funds this is the book to read. Evidenced-based investing information at its best!

—Paul Merriman, Author, We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement

Is there a choice between values and value in investing? Not always. Adams and Swedroe answer this question and many others that all investors must ask about ESG and sustainable investing. This impressive summary dispels myths and simplifies an evolving investment landscape with clear definitions and evidence. I hope many investors will read it, discover the power in the paradox, and use the principles to reclaim prosperity for all.

—Tammira Philippe, CFA, President and CEO, 
Bridgeway Capital Management

As investors increasingly look to align their holdings with their ESG preferences, it’s important to look beyond ESG branding and evaluate whether a fund focused on environmental, social, or governance objectives meets specific, individual goals and desires. Your Essential Guide to Sustainable Investing by Sam Adams and Larry Swedroe provides key tools to help optimize this evaluation process and guide investors to their preferred destination.

—Dave Butler, Co-CEO, Dimensional Fund Advisors

A central question facing investors is whether to embrace so-called 
environmental, social, and governance (ESG) investment products. The temptation to have a positive impact on societal problems like climate change and social justice is overwhelming. Virtually every asset manager has responded with ESG-labeled products. Swedroe and Adams have carefully analyzed this difficult decision and whether the costs to investors outweigh the psychic and monetary benefits of ESG investing.

—Robert Huebscher, CEO, Advisor Perspectives

Larry dedicates this book to the memory of Larry Goldfarb, the best friend one could have

Also by Larry Swedroe

What Wall Street Doesn’t Want You to Know: How You Can Build Real Wealth Investing in Index Funds

Rational Investing in Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today

The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Invests Today

The Only Guide to a Winning Bond Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today

The Successful Investor Today: 14 Simple Truths You Must Know When You Invest

Wise Investing Made Simple: Larry Swedroe’s Tales to Enrich Your Future

The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly

Wise Investing Made Simpler: Larry Swedroe’s Tales to Enrich Your Future

The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments

Investment Mistakes Even Smart Investors Make and How to Avoid Them

The Quest for Alpha: The Holy Grail of Investing

Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals

Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today

Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility

The Incredible Shrinking Alpha: How to be a successful investor without picking winners

Your Complete Guide to a Successful and Secure Retirement: The definitive resource for anyone entering retirement

About the authors

Larry Swedroe

Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners. Larry holds an MBA in finance and investments from New York University and a bachelor’s degree in finance from Baruch College. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has since authored nine more books and co-authored seven books on investing and financial planning. His books have been published in seven languages. Larry is a prolific writer and contributes regularly to EvidenceInvestor.com, AdvisorPerspectives.com, and AlphaArchitect.com.

Sam Adams

Sam Adams is CEO and co-founder of Vert Asset Management, a dedicated ESG investment management firm. He has been a featured speaker on sustainable investing at financial advisor conferences in the US, UK, Europe, and Australia.

Prior to launching Vert, Sam spent almost 20 years working at Dimensional Fund Advisors. He started Dimensional’s European Financial Advisor Services business and led it for ten years.

Sam has a BA in Philosophy from the University of Colorado, Boulder and an MBA in Finance from the University of California, Davis. Sam is an avid mountaineer and cyclist, and is very passionate about the environment.

Acknowledgments

I would like to thank the management team at Buckingham Wealth Partners for all their support in educating investors. I also thank the love of my life, my wife, Mona, for her support and encouragement throughout our 48 years together. Walking through life with her has truly been a gracious experience. And finally, I would like to thank all those who have given so graciously of their time in sharing their investment wisdom. There are too many to mention, so my apologies if your name is not on this short list. Special thanks to my friend and co-author Andrew Berkin, Wes Wellington and the entire research team at Dimensional, Vladimir Masek, and Cliff Asness and the entire research team at AQR. I cannot thank you enough.

Larry Swedroe

I would like to thank my wife and business partner, Sarah, for being my inspiration, my support, and my go-to resource for this book. Her expertise in sustainable investing and her editing assistance has made this a better book. I’d also like to thank Dan Wheeler, Professor Brad Barber, and John Elkington, collectively the Vert Advisory Board, for keeping my thinking up to date, evidence-based, and clear. A big thank you to my mom, Nancy, for reading every word to excise the industry jargon. I also give thanks to every individual making sustainable choices, and my deepest appreciation to those making sustainability their cause. Finally, I’d like to thank Larry for partnering with me and teaching me the art of writing.

Sam Adams

Sam and Larry would like to thank Sandy Hickman for her editing efforts. She was such a pleasure to work with. We also thank Nick Ledden for his editing work, and Nick Fletcher at Harriman House for his outstanding work and contributions editing the numerous drafts. We also want to give specific thanks to CNote for the use of their History of SRI for Appendix A, and to the Plan Sponsor Council of America (PSCA) for the use of their excellent ESG Resource Guide for Appendix D. And finally, we would like to thank Craig Pearce, our editor at Harriman House, for believing in our project and providing his support.

Foreword By Burton Malkiel

Almost $22 billion flowed into investment funds with a sustainable objective during the first quarter of 2021. According to Bloomberg Intelligence, global assets with presumptive environmental, social, and governance (ESG) objectives may surpass $41 trillion in 2022 and $50 trillion by 2025 (more than a third of the total funds under management). The financial industry has responded by providing a plethora of new ESG funds and by rebranding existing funds. Such funds are advertised as helping to achieve a more sustainable world while enhancing investment retu rns as well.

There is clearly a strong demand by investors to ensure that their investments are consistent with their ethical principles. In addition to meeting financial goals, there are potential emotional benefits from investing. People want to align their investment strategies with their societal values. It would also be unambiguously advantageous if they could push the firms in which they invest to improve societal outcomes while simultaneously enhancing their financial returns. But do the investment products that advertise themselves as ESG-compliant actually deliver? How do you know if your investments will have the desired social impact? And is sustainable investing really a way to assure investors they can do well by doing good?

Amid all the hype concerning sustainable investing, there has been far too little attention paid to careful analysis of exactly what such investing really entails and what the evidence shows about its effectiveness. There is also far too little serviceable advice for investors who wish to invest sustainably. Adams and Swedroe have brilliantly fulfilled these needs with their highly readable and evidence-based guide for investors. Here they show what sustainable investing is, why one might want to do it, what financial returns have been achieved, and what its impact has been, as well as the pitfalls that exist. They also provide practical investment advice for individuals wishing to build ESG portfolios.

We learn that meritorious investments are in the eye of the beholder. The objectives of faith-based investment funds are far different from those that prize enhancing the goals of fair pay and inclusiveness. The most common and popular of such funds are those with explicit ESG objectives. But even then, the term means different things to different people, and it is difficult for investors to understand exactly what the ESG portfolios actually achieve. To make matters worse, the ESG scores for different companies published by the professional rating services provided to portfolio managers differ materially. Correlations of ratings between different rating services are as low as 0.42. To put that number in perspective, the correlations between the bond ratings of S&P and Moody’s are more than 0.99. ESG raters cannot even agree when they are considering the same attribute, such as carbon intensity. Within the electric utility industry, a company with one of the biggest carbon footprints is Xcel Energy. Xcel is ranked poorly by some raters because it generates a substantial share of its power from coal. But Xcel is the first U.S. utility committed to going 100 percent carbon-free by 2050 and is a leader in building wind-generation facilities.

ESG ratings also differ markedly for companies for which carbon footprint is not a major factor. Apple gets a high ESG rating of 73 percent from Refinitiv. S&P Global rates them only 23 percent and close to the bottom of their 22-company industry. Even on the identical ESG component of governance, ratings are not even close to one another. Sustainalytics considers Apple’s management among the most compliant with the best governance criteria, while MSCI considers Apple’s governance score second to last in its peer group.

If carbon footprint and governance are major factors in excluding companies from a broad ESG portfolio, what kinds of companies are favored for investment? Examining the top holdings in the largest ESG mutual funds and ETFs, we find Alphabet (Google’s parent) and Facebook, as well as Visa and MasterCard, prominently featured. These companies have had their fair share of controversies. Would all ESG investors really have their social consciences assuaged by investing in companies that have been found to breach individual privacy and impose exorbitant interest rates?

What about the returns from sustainable investing? The authors do a masterful job of meticulously documenting the existing empirical studies. There is no better survey of the returns from ESG investing. Again, the studies do not suggest a clear conclusion. Some studies report market-beating risk-adjusted returns, while others come to the opposite conclusion. There is no unambiguous evidence that sustainable investing enhances long-run financial performance. Moreover, sustainable funds have higher management expenses than traditional index funds. The authors do believe, however, that avoiding certain companies can reduce so-called tail risk—the risk, for example, that a company that cannot or will not curtail its polluting activities could be severely harmed by government fiat. Thus, ESG investing can be a risk-reducing strategy.

One of the very important insights in this book concerns the differences we should expect between short- and long-run returns. This insight can help explain some of the different empirical results. A heightened demand for ESG-compliant investments can cause share prices to rise and thus enhance the returns of sustainable funds. But then so-called green stocks will sell at higher valuation multiples and lower long-run required rates of return. Thus, any short-term benefits will be realized at the expense of long-run performance. Investors who wish to invest sustainably should have reasonable expectations, including a willingness to accept lower long-run returns.

A further important insight concerns the likelihood that an ESG influence on share prices will affect corporate behavior. If ESG-compliant companies enjoy higher share prices and a lower cost of capital, then they will be incentivized to improve their ESG ratings. Thus, a focus on sustainable investing can cause companies to behave in a more positive manner.

Adams and Swedroe then turn to a survey of the empirical evidence on whether sustainable investing is actually making companies more responsible. They cite a number of studies that suggest that ESG concerns by investors have had a positive effect in encouraging firms to take actions that have positive societal impacts,