What are the risks?
All investments involve risk. Economic cycles and external social, political and legal impacts can impact an investment, as can a company’s internal business environment. An investment’s growth and earnings may not keep up with inflation, while changing exchange rates can also impact a company’s profits. Taking a specific investment approach, including a socially responsible investment (SRI) one, can also create its own set of risks.
SRI and diversification risk
Many SRI investors use a negative screening method to screen out companies that don’t meet their ESG standards. But by excluding or under-weighting companies, they reduce the investable universe. This may eliminate some highly profitable companies from their portfolios, as well as the diversification benefits that they could provide during times of market turbulence.
However, research has also shown screening out companies with high ESG risks may provide more favourable returns over time. That’s because companies with poor environmental, social or governance practices face significant risks in the long-term, which can impact them financially. For example, as the world inevitably shifts to renewable energy, a coal mining company’s share price could be severely impacted if it is left with fossil fuel assets that have lost their value.
How SRI can reduce risk?
Investing using SRI principles may help guard investors against a range of risks, including:
Negative practices or incidents, like child labour or an oil spill, could result in media or public action against a company. This could damage its reputation and lead to reduced sales and management issues.
This is the risk of litigation if a company’s products or services demonstrate an accidental or willful failure in their duty of care, resulting in legal action by victims, and significant financial and reputational damage.
Well-known examples include legal action against asbestos and tobacco companies.
Changes or pending changes in regulation, such as laws to restrain coal seam gas exploration, can increase costs, reduce revenue and lead to financial loss and reputational damage if the company faces legal challenges.
Failing to recognise or act on changing consumer demands related to SRI trends, such as more fuel-efficient vehicles, can result in reduced competitive advantage.