Values-based investing explained: The key rules to do it successfully
Editorial staff, J.P. Morgan Wealth Management
- Values-based investing involves choosing investments that are aligned with your beliefs.
- You can incorporate your values by considering environmental, social and governance (ESG) factors as well as the broader impact of each investment on society.
- To get started with values-based investing, you can define the principles that will guide your investment choices and set measurable objectives.
Values-based investing refers to making investment decisions according to a set of principles – either your own personal principles or those of an institution if you’re investing on behalf of a company or a larger group.
There are several approaches to values-based investing, as well as key rules to know and steps to take to get started.
Approaches to values-based investing
There are different approaches to selecting investments under a values-based investing model, including the following:
- ESG integration: This involves using environmental, social and governance (ESG) data to evaluate a company from an economic perspective, including how factors such as labor and environmental practices and board diversity impact a company’s valuation and potential future performance.
- Screening: Negative screening involves excluding companies in certain industries or sectors on moral or ethical grounds. Common examples include not investing in tobacco companies or weapons companies. Positive screening involves selecting companies that are top performers using values-based metrics, such as clothing companies with the lowest carbon footprint.
- Thematic investing: This includes selecting investments based on specific values-based themes, such as companies focused on gender equality or clean energy.
- Impact investing: This refers to investing to drive measurable social or environmental outcomes alongside returns.
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Getting started: Clarifying your values and objectives
To get started with values-based investing, you’ll need to determine which values you’ll focus on and what your objectives are. To do this, be prepared to take the following steps:
- Identify focus areas: Select the factors that will impact your investment choices. These might include climate transition, human capital, community development or faith‑based constraints, for example.
- Define intent: Some investors may use values-based investing to manage risk, such as avoiding companies with potential exposure to environmental liabilities. Others may want to align their investments with their personal values, regardless of whether doing so affects outcomes. Other investors may hope to achieve actual measurable results through investing.
- Set targets and constraints: Once you’ve defined your goals, translate them into rules for building a portfolio, such as prioritizing investments in companies with diverse boards or excluding investments like fossil fuels.
- Determine time horizon, liquidity and return requirements: Outlining your requirements can help you evaluate whether your investments meet practical financial needs.
Tools and vehicles to build a values‑aligned portfolio
There are several tools you can use as an investor to build a values-aligned portfolio. Let’s walk through them:
- Public markets: ESG funds and ETFs (exchange-traded funds) pool investor money to invest in companies that meet ESG criteria. There are also actively managed funds for which professionals analyze ESG data and other metrics to select investments, while screened index strategies either remove or overweight investments based on key factors like the exclusion of fossil fuel companies.
- Thematic allocations: This involves building a portfolio based around companies that support or excel on specific goals, such as clean tech, energy transition, water, health equity or inclusive finance. Because themes can be sensitive to economic cycles, diversification is important to avoid outsized risk of loss.
- Cash and fixed income: Investors looking for relatively lower-volatility options (which still involve risk) may consider bond funds that raise capital for specific projects like renewable energy initiatives or investing in community development financial institutions that cater to underserved communities.
Taxes and account location
Values-based investing doesn’t eliminate the need to use tax-efficient investing strategies.
For example, values-based investors may wish to hold actively managed investments or funds with high turnover in tax-advantaged accounts – such as individual retirement accounts (IRAs) or 401(k)s – if those investments would otherwise produce frequent distributions subject to capital gains tax.
Such strategies may help investors to continue following values-based principles, including excluding certain industries or prioritizing companies focused on environmental and social issues, while still seeking to improve tax efficiency.
Performing due diligence and avoiding greenwashing
With values-based investing comes the risk of greenwashing. Greenwashing involves companies, funds or advisors exaggerating the environmental and sustainable practices they’ve implemented in their operations or investment decisions.
It’s important to do your due diligence to avoid this by using some of the following techniques:
Look at data and standards
ESG data isn’t standardized, so determine the data sources, definitions and weightings that companies or fund managers use. For example, one provider might focus on labor practices and another on corporate governance. Look deeply at metrics, such as how companies are screened in or out, and how issues like environmental violations are reflected. Make sure the methodology is published and prioritize providers that open themselves up to independent audits or third-party verification of their methods.
Evaluate the manager’s process
For actively managed funds, you may want to request a walk-through of the manager’s process, from generating ideas to making final investment choices. Ask for examples of how ESG considerations impact their decision-making at each step; doing so may help you assess whether ESG is just a marketing tactic or a meaningful part of the investment selection process. You can also check the manager’s record of company engagement and proxy voting to confirm consistent policies and find proof that actions have led to change, such as evidence of improvements in ESG metrics in companies the manager has engaged with.
Develop an investment policy statement
An investment policy statement outlines your investment goals and limitations, as well as your decision-making framework. Draft one that establishes your priorities, such as excluding fossil fuel companies or including companies with diverse boards. Keep a list to record how your values are applied in practice – like which companies you’ve excluded and which you hope to impact through engagement – and set review timelines to help ensure accountability.
Measuring success: Metrics to consider
Like with any approach, it’s important to measure the success of your values-based investing strategy. Benchmarking, or comparing your portfolio to a standard index such as the S&P 500, can be an effective way to do that. As you compare your portfolio to the benchmark, consider the following:
- Returns: Is your investment performing better or worse when it comes to returns?
- Risk: Are your investments more or less volatile than the benchmark?
- Tracking error: How much does your fund deviate from its benchmark? Since values-based portfolios often exclude entire categories of investments, like fossil fuels, there’s often higher tracking error (i.e., the portfolio behaves meaningfully differently from the benchmark). This can lead to greater potential for either overperformance or underperformance.
With ESG investing, you’ll also need to measure how successful your investments are in aligning with your values. This can mean looking at the companies you’re investing in and evaluating such factors as:
- Carbon intensity: This refers to emissions relative to revenue.
- Financed emissions estimate: This figure represents the total emissions tied to your investment portfolio.
- Board/diversity metrics: What percentage of underrepresented groups are on the board?
- Safety or labor indicators: What are employee turnover and injury rates? Has the company been tied to any controversies?
- Impact KPIs tied to themes: For impact investing, consider key performance indicators (KPIs), like the number of housing units built by the affordable housing company you invested in or the number of megawatts generated by a clean energy company.
Review quarterly performance as well as annual impact/engagement reports to evaluate these factors.
If you’re focused on impact investing and trying to orchestrate change, also consider things like shareholder resolutions that were filed, votes on ESG issues and whether direct engagement with company management has led to real outcomes.
How to implement a values-based approach to investing
Implementing a values-based approach to investing comes down to taking a structured set of steps. You may want to do the following:
- Define your values and objectives and codify them in your investment policy statement.
- Select the investment tools, vehicles and investment managers to ensure your investments align with your chosen criteria.
- Develop a transition plan to begin values-based investing, including making tax-efficient investments, limiting trading costs and reducing tracking errors as you reallocate your assets.
- Set a monitoring schedule and a process for measuring performance and recognizing style drift.
- Create a plan for rebalancing as needed.
- Align your philanthropy efforts, spending and investing as much as possible to maximize your impact.
Trade-offs and practical considerations
It’s important to recognize the trade-offs and practical matters that could impact your commitment and ability to practice values-based investing. These include the following:
- Return expectations and dispersion: Your returns may deviate from the broader market.
- Sector tilts: Many values-based investing strategies end up overweighting or underweighting certain sectors. For example, you might invest heavily in tech but have limited exposure to energy. This can lead to risk dispersion, which means there’s a wider range of possible outcomes compared to investing in a broad index such as the S&P 500.
- Cyclicality of themes: Some investments perform well only during specific parts of the economic cycle.
- Potential tracking error: Your investments may significantly underperform or overperform your benchmarks.
- Diversification: Investing too heavily in any one area can increase volatility and risk, so keeping core allocations broad is critical.
The bottom line
Values-based investing can help you avoid supporting businesses that are misaligned with your values. In some cases, it’s even possible to make a direct impact through your investments. The key is to ensure you have a clear mission and metrics for success, so your investments can both grow your wealth and help you do your part in creating a better world.
Frequently asked questions about values-based investing
Values-based investing will not necessarily lead to underperformance. Some investments may be capable of generating returns similar to a more traditional benchmark investment.
Green, social and sustainability bonds are bonds used to fund projects or activities with a positive impact. Green bonds support environmental projects like renewable energy. Social bonds support projects that address social issues like affordable housing. Sustainability bonds finance a combination of green and social activities.
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