Explaining the S: Putting Social in ESG

Posted by FlexShares on Jul 24, 2017 8:30:00 AM


Environmental, social, and governance (ESG) investing is increasingly taking center stage among investors whose intention is to build a portfolio that aligns with their values. As such, ESG investing is of increasing interest to the financial advisors who serve these clients. Of the three legs of the ESG stool, the social aspect often proves difficult to define. Gauging how well a particular company fits the social requirements of an ESG strategy begins with a deeper understanding of both the activities "social" encompasses, as well as the outcomes they're intended to produce.

Designing the Social Mold

One of the focal points of the social element of ESG investing is how a particular company approaches relationships with both its employees and other businesses. Primary concerns for investors and advisors include the company's promotion of its workers' health and safety, its efforts to safeguard human rights, and the integrity of its products.

The latter involves ensuring that products are both ethically-tested and manufactured, and that they are safe for consumers. A focus on emerging technology issues with regard to product development and a commitment to innovation are also hallmarks of companies that operate within a socially responsible framework.

Diversity is another concern that features prominently in ESG investing. The emphasis here is on companies that employ a more inclusive strategy with regard to both recruitment and hiring of their employees.

Finally, companies may be evaluated on how well they meet social criteria based on the imprint they leave on local and global communities. Specifically, that refers to whether a company engages in philanthropic activities, such as responsible lending, charitable donations, or volunteer work.

General Gauging the Effects of Social Activities

Defining which activities fall under the social umbrella is one part of the puzzle; understanding how those activities may correlate to a company's financial performance is another.

Activities that center on the workplace, such as implementing policies that protect the health and safety of employees or encouraging positive relations between labor and management, can yield a measurable impact in terms of increased productivity or a reduction in turnover. Companies may also see a rise in morale as a byproduct of engaging in socially-driven activities.

With regard to product integrity and consumer protection, the most direct benefit may be an increase in sales. When consumers trust a company's products, they may be more inclined to spend their money on them rather than a competitor's products. Strong sales performance can potentially solidify a company's position in the marketplace, while potentially increasing its value in the process.

Engendering brand loyalty through social activities may also serve to strengthen a company's reputation. We believe that managing reputational risk is critical for preserving the bottom line, as damage to a company's good name could result in financial losses.

We believe that making sense of the social component is important for both investors and advisors who adopt ESG strategies. Understanding the how's and why's of social investing—and their correlation to the environmental and governance criteria—are instrumental in building portfolios that are designed for maximum impact.

Correlation measures the strength of the relationship between the returns of two investments. It can range anywhere from +1 (perfect correlation) to -1 (perfect negative correlation). If two investments are perfectly correlated, they will always increase or decrease in value at the same time.

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FlexShares STOXX® US ESG Impact Index Fund (ESG) and the FlexShares STOXX® Global ESG Impact Index Fund (ESGG) are passively managed and use a representative sampling strategy to track their underlying index respectively. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index. The Funds are subject to environmental, social and governance (ESG) Investment Risk, which is the risk that because the methodology of the Underlying Indices selects and assigns weights to securities of issuers for non-financial reasons, the Funds may underperform the broader equity market or other funds that do not utilize ESG criteria when selecting investments. The Funds are also at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. For ESGG, investments in foreign market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. The Funds may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested.

The STOXX® USA ESG Impact Index and the STOXX® Global ESG Impact Index are the intellectual property (including registered trademarks) of STOXX® Limited, Zurich, Switzerland and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by STOXX® and its Licensors and neither of the Licensors shall have any liability with respect thereto.

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