CFA Institute-Led Group Publishes New Definitions for Responsible Investment

In an effort to standardize terminology and enable institutional investors, regulators and industry participants to communicate with precision about environmental, social and governance investing and other responsible investing terminology, the CFA Institute recently published new definitions for sustainable finance-related terms.  

Margaret Franklin, CEO and president of the CFA Institute, said that this project is “critical to ensure that professionals can communicate efficiently and effectively with each other, as well as investors and industry professionals across the market.” 

The definitions report was published as legal challenges continue to the Department of Labor’s rule permitting the consideration of ESG factors when selecting investments for defined contribution retirement plans, along with other conflicts at the state and federal over the role ESG in the proxy voting process and other systems. 

The CFA Institute collaborated with the Global Sustainable Investment Alliance and the Principles for Responsible Investment to harmonize definitions for the following responsible investment terms: 

• Screening 
• ESG integration 
• Thematic investing  
• Stewardship 

• Impact investing 

Chris Fidler, head of industry codes and standards at the CFA, said in an emailed response to questions that well-defined terminology is essential for clear communication. 

“Unclear and inconsistent terminology can cause confusion in the marketplace, making it harder for both clients and investment managers to achieve their goals,” Fidler said. 

For this project, Fidler said the CFA selected commonly used terms that needed additional clarity and consistency. 

“We focused our efforts solely on terms associated with responsible investment approaches, but these are not the only sort of terms that cause confusion,” Fidler said. “Greenwashing, for example, is a frequently used term that does not have a precise and consistent definition.” 

Screening 

Screening is the process for determining which investments are or are not permitted in a portfolio. According to the CFA, this process is used for attaining an investment focus, complying with laws and regulations, satisfying investor preferences and limiting risk. 

The new definition for screening is “applying rules based on defined criteria that determine whether an investment is permissible.” The defined criteria can be qualitative or quantitative.  

For example, criteria can be whether the issuer or security in question is a constituent of a specific ESG-related index or whether a sovereign issuer achieves a given human rights performance score from a specific ratings provider. 

The CFA argued that if rules are not based on defined criteria and applied consistently, the activity should not be characterized as screening. 

ESG Integration 

ESG integration should be defined as the ongoing consideration of ESG factors within an investment analysis and decision-making process with the aim to improve risk-adjusted returns, according to the CFA.  

This integration involves identifying and assessing the ESG risks and opportunities that are relevant to investments, weighing that information and making decisions about those investments. The CFA argued that this is an ongoing part of the investment process—not a one-time activity. 

Consideration of ESG factors, however, does not imply that there are restrictions on the investment universe and that ESG factors are given more or less consideration than other types of factors. 

“When communicating to general rather than professional audiences, investors should avoid the term ‘ESG integration’ and instead use plain language to accurately describe how ESG factors are considered in the investment process,” the CFA recommended in its report. 

Thematic Investing 

Thematic investing, according to the CFA, involves selecting assets to access specified trends. 

“Thematic investing is underpinned by the belief that economic, technological, demographic, cultural, political, environmental, social, and regulatory dynamics are key drivers of investment risk and return,” the report stated. 

This term essentially refers to selecting companies chosen in a top-down process for inclusion in an investment portfolio that fall under a sustainability-related theme, such as clean technology, sustainable agriculture, health care or climate change mitigation.  

The CFA noted that thematic investing differs from constructing a portfolio with a particular focus. For example, investors may wish to invest in a portfolio of a veteran-owned business because they want to support veterans while earning a financial return, but this would not be considered “thematic investing” unless a case was made for how veteran-owned business enable access to a specified trend or trends. 

“Thematic investing often—but not always—results in a focused portfolio, but not all focused portfolios are the result of thematic investing,” according to the report. 

Stewardship 

In the context of ESG, stewardship refers to “deliberate deployment of rights and influence (beyond capital allocation) to protect and advance the interests of those clients and beneficiaries.” This includes the common economic, social and environmental assets on which their interests depend. 

Some examples of ways in which investors can exercise their rights and influence include serving on or nominating directors to a company’s board, filing shareholder resolutions or statements and voting on proposals at shareholder meetings. 

The CFA argued that the term stewardship should not be used to refer to activities like proxy voting and engagement unless these actions are “undertaken to protect and enhance overall value for clients and beneficiaries.” 

Impact Investing 

Lastly, the CFA defined impact investing as investing with the intention to generate positive, measurable social and/or environmental impact alongside a financial return.  

Impact investing can be pursued across a range of asset classes, including fixed income, real assets, private equity and listed equity investments, according to the CFA.  

This concept differs from philanthropy in that it pursues a financial return in addition to a positive, measurable impact. Impact investors have discretion over the rate of return they target. 

Wilshire Advisors LLC also recently released a report arguing that while ESG stands for environmental, social and governance, “its meaning differs from individual to individual and from organization to organization.”  

The Wilshire report argued that ESG investing is too often viewed monolithically deemed either “good” or “bad.” 

“Ultimately, considering all ESG ‘good’ or all ESG ‘bad’ is not prudent,” the Wilshire report stated. “This binary view fails to acknowledge the nuances of ESG investing. Like any investment, the product, people and process matter. Furthermore, this view of ESG limits the ability to see that folks on either side of the debate have a lot more common ground than the headlines and rhetoric would suggest.”