Welcome to this course where we'll be taking a look at ESG investing from the investor perspective. I'm Chris Geczy, I come to the subject of social investing both as a teacher and a practitioner. Before we get to the core of this course, there'll be a brief introduction. We'll put the experience of social investing in ESG in the context of today's financial markets, and the relationship to the markets different types of investors may have. We'll also define some important terms, especially for the benefit of those who might not have a background in finance or be highly knowledgeable about investing. Throughout this module, we'll be asking and hopefully answering the most important questions that investors, whether they are professionals investing large portfolios for an institution, or individuals investing for retirement. The latter type of investors are called retail investors in the investment industry, so there's our first term defined. Now then, although you've no doubt heard the term before and may be familiar with it, what is ESG? ESG is an abbreviation for Environmental, Social, and Governance related investing. These are three types of goals favored by investors who look for social as well as financial returns on their investments. ESG is currently the most popular term for this type of investing, which is also sometime known as socially responsible investing, especially where eliminating certain investment from portfolios is afoot. Sustainable investing, investing with a purpose, and in some cases impact investing. We could go over a few of the names if we had unlimited time, but regardless of the name, the idea is to earn financial returns while causing or associating with social impact, or issuing characteristics on ESG bases of investments in a portfolio. What is this positive social impact? Well, that really depends on the values of the investor. Beauty as always is in the eye of the beholder so to speak. Popular social and environmental and governance goals include limiting climate change, promoting diversity, making corporations act more responsibly, or issuing investments that are anathema to you or to investors. But an investor can adopt any social goal, which could be expressed through his or her investments. For example, if she believe it's a good thing for people to drink liquor, smoke cigarettes, and gamble, there's a mutual fund investing in companies which do that. ESG or social investing can be thought of as a set of techniques, or approaches, or characteristics oriented toward achieving social goals, through the act of investing in enterprise, but not necessarily a laundry list of particular goals. Now, for some definitions of useful terms which we'll encounter throughout the course. First, risk and risk-adjusted return. According to the tenets of fundamental classical academic finance called Modern Portfolio Theory or MPT, every investment has an associated risk, typically measured with volatility, a measure of uncertainty. Of course, some are more risky than others. For taking more risk, rationally speaking, an investor should expect to earn a higher return. Theoretically, the least risky or risk-free investment is often associated with short-term US government debt called Treasury Bills backed by the full faith and credit of the US government, and due over very short horizons. That rate of return i.e, the risk-free rate, is very low these days almost zero, and in real terms may be negative. An investment such as a company stock or a fund with the stocks of many companies should potentially have a higher return as well as more risk than the risk-free security return. A risk-adjusted return is the calculation of expected or realized financial return on an investment taking into account the risk the investor took on. That can be measured systematically, idiosyncratically, or by way of combining all risks to the other known as total risk. Risk is typically expressed again in terms of volatility. That is the rate of change in an investment's price measured as a deviation from expectation. Higher volatility typically means more risk. Of course, other measures of risk including downside risk, the risk of loss, the risk of bankruptcy, or a permanent impairment of capital are also commonly used measures of risk. Interestingly enough, all these measures are often highly correlated themselves. A rational investor of course always seeks the highest return possible condition on other preferred characteristics including risk in their investments. But every investor also has a limit to the amount of risk they're willing to take, otherwise known as their risk tolerance. An optimal risk-adjusted return is the highest return an investor could expect to earn or did earn historically forensically for a given level of risk or the lowest level of risk available for return given the investor's preferences. In the course, we'll examine how ESG investing affects risk-adjusted returns, and in general how ESG fits into the types of investing most people do. The key question for most investors is whether ESG investing has a cost compared to regular investing, and if so, in under what conditions do we see a cost? Or, is it actually possible to earn higher financial returns through ESG investing? Some investors are willing to accept a lower financial return to achieve social goals, others are not. The answers for different investors simply put may be different and optimal. Investment diversification. ESG investments must be considered in the context of a well-diversified portfolio as well as on a pure line-by-line, one-by-one comparable basis because that's what most investors have. In fact, the largest investors typically such as pension funds, foundations, sovereign wealth funds, and others are required to have well-adjusted or well-diversified portfolios in many legal regimes. Diversification is an important tool for reducing risk. According to typical financial theory in the aggregate, adequate diversification and keeping fees low, are often the two best ways to earn returns. In some cases, fees might be associated with referred outcomes, so the question varies by investor, as of course does the answer. Timing the market and active management, i.e, stock picking, may add value for some investors, it may not add value for some investors. In the course, we will also look at how ESG investing affects diversification and potentially fees. Fiduciary responsibility. If you're investing someone else's money , you are a fiduciary. Fiduciaries have a strict set of legal duties including acting in the client's best interests, putting the client's interests first, and avoiding conflicts of interests among others. It's a critical ongoing question in the ESG and impact investing space, as to how fiduciary responsibility interacts with various avenues toward the implementation of ESG characteristics. We'll examine how ESG investing fits in or doesn't fit within fiduciary duty. Performance measurement. With ESG investing there are two types of performance measurement at least: financial and social governance, or environmental. Financial returns are often measured the same way as other non-ESG investments; absolute return, risk-adjusted return, systematic risk-adjusted return, and of course total risk-adjusted return which adds what's known as the Sharpe Ratio. The Sharpe Ratio named after Professor Bill Sharpe is a formula which determines if the investor earned or would earn a higher return holding risk constant or, a lower risk holding return constant. It's typically measured as the return above the risk-free rate divided by volatility or expected volatility and expected return of any given investment singly or in a portfolio. Measuring social returns is more complicated. We'll discuss it in some detail later in the module. Modern Portfolio Theory classically considers expected return in volatility in determining optimal investment allocations. When we add ESG and related considerations to this notion of investor utility or preference, the dimensionality of what investors care about can expand dramatically. There may be tradeoffs among all of those considerations, once again including the Sharpe Ratio. Now to the core of ESG and impact from the investor's perspective. We've organized the course as discussions of some key questions which most ESG investors are very interested in.
