Taking the first step down the path of environmental, social, and governance (ESG) investing can introduce some uncertainties for private foundations seeking to pivot in that direction. One of the best ways to allay these concerns is to narrow down the right elements to consider and ask the right questions.
The following six questions can help private foundations determine how to begin incorporating ESG into their investment strategies.
1. Why ESG?
To build a strong foundation for your decision, nail down the reasons you want to embark on ESG investing. Are you primarily concerned with environmental goals, such as addressing climate change? Or do you prioritize the social or governance aspect of ESG? Your foundation’s board should consult with stakeholders and investment managers to establish your focus, as it will influence decisions going forward—ultimately including how to measure impact.
2. Do you have the right leadership and staff?
Having defined your goals, ensure you have the right team to reach them as you carry out your plans for incorporating ESG. Ideally, you will be able to lean on some internal ESG experience from your team as well as have an investment manager who understands what to consider with ESG investments.
3. Will you apply negative or positive screening?
Either negative or positive screening can be used to apply ESG principles to traditional investments. Negative screening aims to exclude stocks or bond issuers that cause adverse ESG impacts; these portfolios would avoid securities in industries such as tobacco or oil and gas.
Positive screening, on the other hand, targets securities with higher ESG scores without wholesale exclusion. For example, oil giant Royal Dutch Shell has a higher ESG rating than Tesla due to its strenuous efforts to increase sustainability. As such, oil and gas companies could still find their way into a portfolio using positive screening.
4. Is your goal mission-aligned investing or direct impact investing?
Mission-aligned investing entails investing in traditional investment opportunities that directly tie to your foundation’s mission with the aims of advancing that mission, creating a positive impact, and generating a financial return. For instance, an overall goal to improve healthcare outcomes may involve investment in companies working in cancer treatment or immunology.
In contrast, direct impact investments tend to be less liquid if your foundation’s funds are invested with social enterprises and nonprofit partners. One example is investing in another foundation’s program to make loans in developing countries.
5. Are you impact first, investment second—or vice versa?
When investing in diversified funds, applying positive or negative screening to traditional investments is likely to generate comparable returns to standard non-ESG funds. In fact, many funds that use positive or negative screening outperform over time.
However, the positive impact that such investments generate can be more difficult to quantify and may be lower when compared with the impact generated through high impact concessionary investments such as community development finance institutions. Although investment returns from mission-related investing can be closer to those offered by ESG funds that use positive or negative screening, returns from concessionary investments may be substantially less, in some cases demonstrating higher impact but lower returns.
6. What is acceptable risk?
Foundations are typically comfortable with investing about 95% of their assets and spending no more than 5% each year. The wide range of investment opportunities available under the ESG label makes it possible for foundations to invest that 95% in ESG-aligned strategies without sacrificing much diversification.
However, draw a line and define acceptable risk—especially as investing too high a proportion of funds in direct impact investments, for example, could bring higher risk. A clear definition will shape how investments are spread, diversified, and managed.
As with the broader trend from investors in favor of ESG, the pieces are in place for foundations to place a fresh emphasis on ESG issues. However, every foundation is unique, so it’s important to answer critical questions before starting the ESG journey to find the best direction. Just as with investing generally, one size in ESG does not fit all.