[Opinion] Points to Consider When Investing Using ESG Factors

Hong Ki-hoon, Professor at the College of Business Administration, Hongik University

[Asia Economy] ESG is hot. From my experience in ESG consulting, I have realized that although ESG has a fairly long history, the perspectives and purposes of ESG are not as well understood as expected. Moreover, it is surprising that even so-called ESG experts talk as if ESG justifies sacrificing shareholders' financial interests for corporate ethics and social activities.

ESG is a concept established based on the six UN Principles for Responsible Investment (UN PRI) announced by former UN Secretary-General Kofi Annan in 2006. Since it started as an investment principle, it is generally mentioned alongside investment.

Among ESG factors, E derives from green and carbon finance, S from SRI investment, and G from ethical investment. In other words, ESG investment can be seen as an attempt to comprehensively implement various financial efforts pursued so far to achieve sustainable growth. Therefore, ESG should be approached from a financial perspective.

Ethical investment, which avoids investing in "sin stocks" (companies that may have socially harmful impacts such as alcohol, tobacco, and casino operations), has existed since the 1760s. Based on this concept, the Pioneer Fund launched the first exclusionary screening strategy fund that avoided sin stocks in 1928, and around the Vietnam War, ethical investment evolved into SRI, socially responsible investment. SRI invests in companies based on various social outcomes such as human rights, environment, labor, and community contribution, as well as financial performance, and this SRI developed into the S in ESG.

I am often asked, "How can we know which industries or companies should be excluded when making ESG investments?" Prohibiting investment in specific sectors, countries, or companies narrows the investment universe significantly. A narrower investment universe inevitably makes it harder to achieve returns. A bigger problem is that exclusionary screening is mostly applied before practical investment analysis.

The fundamental principle of ESG investment is to consider both existing financial information and ESG information when making investment decisions such as security selection and portfolio construction, thereby considering investments in all sectors, countries, and companies within the scope. This means that ESG information should be applied to broaden the scope, not narrow it. Mechanically excluding specific sectors, countries, or companies is not ESG integration but rather contrary to it.

Sacrificing portfolio returns for ESG investment is not right. We must seriously consider why we integrate ESG. It is to reduce investment risk and increase returns. In other words, it is to avoid potential investment risks.

One of the most surprising things to me was receiving numerous questions about how to create a new investment model. They said so-called ESG experts insisted that new investment models must be created to fit ESG.

Investment using ESG factors is still investment in companies. ESG factors are only part of the company. We already have excellent corporate analysis models. It makes no sense to completely change those models to apply ESG. ESG should be seen as a supplementary tool that complements the investment process. If integrating ESG requires a major overhaul of the existing investment process, it is putting the cart before the horse. Simply modifying the investment process to consider ESG information is sufficient.

To summarize: 1) ESG should be viewed from a financial perspective; 2) exclusionary screening of sin stocks is not appropriate; 3) financial returns should not be sacrificed for ESG; 4) there is no need for a new investment model.

[Hong Ki-hoon, Professor, College of Business Administration, Hongik University]

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