This key element of ESG investing could drive real change at companies and boost returns

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A pedestrian passes a Wall Street subway station near the New York Stock Exchange (NYSE) in New York, USA, on Monday, June 27, 2022. Money managers betting on a sustained global recovery will be bitterly disappointed in the second half of a devastating year as a prolonged bear market looms even as inflation cools. Photographer: Michael Nagle/Bloomberg via Getty Images

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As the importance of socially responsible investment strategies becomes more pervasive, advocates are turning their attention to an area they believe is less understood.

The social pillar of the environmental, social and corporate governance investment framework – known as ESG for short – has been dubbed the “middle child” largely because of the data challenges. As ESG has reached new heights in terms of mainstream awareness on Wall Street and Main Street, practitioners in the field now see an opportunity to better define and quantify the “S” pillar.

“There has been significant growth,” said Michael Young, director of education and programs at the Sustainable Institute Forum. “But of the three, it is definitely the newest to be included in an investment process. And not everyone will use it the same way.”

For years, the social pillar was considered relatively nebulous and difficult to quantify. BNP Paribas found in 2021 that more than half of the 350 institutional investors surveyed globally believed that the “S” was the most difficult to analyze and integrate.

At the same time, the topics of climate and corporate governance are becoming increasingly popular. This happened in part because climate change and racial justice have become more prominent in recent years, pushing investors and company executives to pay more attention to companies’ performance in these categories. This is despite the fact that the ESG investment framework has run into political difficulties.

Now investors need to understand what the “S” means to them and how to best analyze companies’ efforts in this area.

Define and quantify the “S”.

The elevator pitch definition for the social pillar usually goes something like this: It’s about how companies interact with their communities, both in terms of their workforce and the locations in which their company operates.

While data on human capital and diversity has improved in recent years, investment professionals still see a lack of standardized information that can make it difficult to integrate social issues. The patchwork of data can also make direct comparisons between competing companies difficult.

Looking forward, Young said a possible human capital disclosure rule from the Securities and Exchange Commission is being watched by advocates. They hope the rule will result in a database of information from companies provided to the Equal Employment Opportunity Commission being made publicly available.

“That would be a huge catalyst,” he said. “It would be the first-ever ‘S’ disclosure rule in the United States.”

In the absence of sufficient standardized data, some have gotten creative.

Marian Macindoe, head of ESG stewardship at Parnassus Investments, said data on the proportion of part-time and full-time employees, benefits for contract workers and evidence of best practices in hiring needed to be taken into account. She said Parnassus often asks for engagement data from companies, but acknowledged that it is an imperfect way to measure performance.

When searching for information, her team checks to see if there are any publicly available fines or lawsuits against a company. Even reviews on Glassdoor or memes posted on social media platforms that address general topics can provide user insights, she said.

The company wants companies to know: “This is important — and you should be held accountable for it,” she said.

Harbor Capital and Irrational Capital have teamed up to create exchange-traded funds thematically focused on employee satisfaction: These include the Harbor Human Capital Factor US Large Cap ETF and the Harbor Corporate Culture Small Cap ETF.

Fittingly, the funds trade under different tickers – like HAPI and HAPS – that use the same first three letters as the word “happy.”

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The large cap vs. small cap fund this year

The funds use survey data that Irrational has collected from more than 15 million employees at several thousand companies. This is useful because the company believes that strong employer-employee relationships can lead to better company performance and therefore rising shares.

Big tech names like Microsoft, Apple, alphabet And Meta were among the largest positions in the large-cap fund in mid-November. In the meantime, Insperity, HB Fuller, Apple hospitality And Evercore are among the largest holdings in the small cap variant.

Elsewhere, socially responsible investors view the role of companies in the communities in which they operate as part of the “S.” Macindoe said companies sometimes confuse this with mere charity work rather than being active members of the community.

“Charitable giving and philanthropy are really great, but that’s not the ‘S’ of ESG,” she said. “The ‘S’ in ESG is about taking care of the people who rely on you and who you rely on to plan your business strategy and operations.”

There can also be overlap between environmental and social issues, which can sometimes cause confusion, according to Yijia Chen, vice president at Calvert Research and Management, an early advocate of socially responsible investing. In these cases, the social pillar comes into play to ensure that the CO2 transition is fair and equitable.

A tense environment

Globally, it appears that social issues are becoming increasingly clear and important to investors over time.

This year, BNP Paribas found that investors around the world said a company’s commitment to workers’ concerns would become a greater priority in voting or investment decisions over the next two years. (BNP Paribas specifically examined issues such as fair pay and equal treatment. The company also asked how investors view the importance of a company’s promotion of diversity, equity and inclusion, or DEI, in the workplace.)

However, North American investors showed a reverse trend: the survey found that these issues will become less of a priority over the next two years. This is because ESG and DEI have been politically contentious over the past year, fueling debate among lawmakers.

In the meantime, there is backlash Goal‘s Pride collection and Anheuser BuschThe Bud Light campaign featuring a transgender influencer has become a symbol of how these so-called culture wars have affected corporate America. RBC Capital Markets found that U.S. companies are increasingly using terms like sustainability instead of ESG when discussing social responsibility in earnings releases.

As the ESG landscape has become more politically fraught, some investors are warning against reactionary moves like divestitures if they don’t see a company living up to socially responsible values.

Instead, they argue that they can have a greater impact by using their power as active investors to advocate for better policies. Many point to materiality and risk mitigation as recurring reasons they give companies why they should care about ESG issues.

Han Yik, a senior retirement planning consultant for the New York State Teachers’ Retirement System, urged attendees at an ESG conference last month to think about the decision to divest like dealing with trash in a backyard. The trash can be taken to a neighbor’s yard or disposed of for the benefit of everyone.

“We’re not a fan of divestment,” Yik said. “We believe that as owners of the companies we can have more influence than if we sold them to someone else.”

Although ESG experts struggle with data issues and general confusion surrounding the social pillar, they say its importance shouldn’t be a particularly hard sell.

“If you’re a business and you don’t take care of the natural human capital that your business relies on, you’re not going to be successful in the long run,” Macindoe said. “It’s just a matter of scanning your landscape and making sure you’re going to be successful in it long-term.”