The “S” has long been considered the middle child of environment, social and governance (ESG) investing.

Climate change risks are front and centre, underscored by the world's largest fund manager, BlackRock, dumping billions in thermal coal investments. Elsewhere, the Volkswagen emissions scandal and the executive misdeeds unearthed in our banking royal commission and have dominated headlines.

But the coronavirus pandemic and a wave of global anti-racism protests in response to the brutal death of George Floyd have brought “social” risks into sharp focus.

"The pandemic is generating wider appreciation for the importance of the ‘social’ dimension of ESG analysis," Morningstar head of sustainability research Jon Hale says.

"When companies do things like increase healthcare benefits, hike pay for workers on the front lines, lower executive compensation to help avoid layoffs, and take extra steps to protect worker and customer safety, they will benefit from having a more-engaged and productive workforce and a more-loyal customer base during a recovery.

"By putting the spotlight on a company’s treatment of workers, customers, and communities, the pandemic is helping advisers and their clients understand that sustainable investing extends beyond environmental considerations."

Social factors evaluate things such as a company’s commitment to inclusion and diversity in the workplace, fair wages; how it acts to prevent forced labour; how it supports its local community; to what extent it ensures customer privacy and product safety.

Social risks surrounding a company's diversity and inclusion policies in hiring and compensation have come to the forefront, exposing several corporate CEOs and leaders spanning media, technology and politics. New York Times opinion editor James Bennet resigned earlier this month following backlash over an op-ed article entitled "Send In The Troops". The CEO of CrossFit Greg Glassman also resigned following controversy surrounding his reaction to Floyd's death.

Closer to home, Rio Tinto (ASX: RIO) has sparked international outrage amid a community backlash over its destruction of a 46,000-year-old Aboriginal cave in Western Australia.

And the fallout from such incidents is taking a toll. The Bank of America estimates that scandals involving ESG issues have wiped more than $500 billion off the value of large US companies over the past five years.

Weighing up the risks

Some investors factor social risks into their investment decisions in the hope of improving the world. Others dump certain stocks because they believe the social risks posed by companies shirking their responsibilities are too great.

However, gaining access to companies with strong racial and ethnic diversity policies is easier said than done, as the Hale research points out.

"There is a grand total of one fund available to US investors that specifically focuses on companies with strong racial and ethnic diversity policies: Impact Shares NAACP Minority Empowerment ETF NACP," Hale says.

This fund tracks a Morningstar index, based on data from Sustainalytics, called the Morningstar Minority Empowerment Index. The index constituents are made freely available for benchmarking purposes. Morningstar earns revenue from the sale of the index to providers.

A growing number of sustainable equity investment funds are built around ESG assessments that typically include the consideration of corporate diversity programs, discrimination policies, and worker health and safety.

Ausbil Active Sustainable Equity fund, for example, is signatory to the Principles for Responsible Investment (PRI) and undertakes to consider environment, social—including labour standards— and corporate governance factors in its investment decision-making and ownership practices.

"Slavery, which encompasses forced labour, bonded labour, human trafficking and child slavery, remains a widespread global issue and a hidden risk in companies’ supply chains," Ausbil said in a statement on slavery.

"This means there is a risk to investors. We believe there is a strong business argument for companies to take an active role in tackling these issues."

In a recent report, BlackRock argues that ESG insights help investors uncover more resilient companies. They also found the outperformance of sustainable funds was "driven by a range of material sustainability characteristics, including job satisfaction of employees, the strength of customer relations, or the effectiveness of the company’s board."

Making workplaces diverse

The Morningstar Minority Empowerment Index focuses on the top 200 US companies that have "embedded strong racial and ethnic diversification policies into their corporate culture and that ensure equal opportunities to employees irrespective of their race or nationality".

The index pursues social objectives by selecting companies with high 'Minority Empowerment Scores', while companies with controversies are deemed ineligible.

Funds that integrate ESG factors into their investment decisions often skew towards healthcare and technology names and away from energy and mining firms. Many of these funds have performed well so far during this year's downturn due to the oil price crisis.

The Morningstar Index's largest sector exposures are technology (19.7 per cent) and Healthcare (14.70 per cent).

Morningstar Minority Empowerment Index top 10 holdings

diversity Index

Source: Morningstar Indexes

A deeper look at some of the names on the list reveals the reason behind their inclusion. Home Depot (HD), for example, is the world's largest home improvement retailer and employs over 400,000 people across its locations.

Sustainalytics says HD has "significantly improved its diversity and inclusion programme in the last two years", with initiatives related to the recruitment, development and retention of its associates. However, they say the company has gaps in the way it reports data on temporary workers.

Another name on the index—Salesforce.com Inc (CRM)—has committed to equal pay through annual pay assessments across its global operations. The company publishes pay equality data regularly.

"Overall, diversity remains a challenge with only 33 per cent of the company made up of women, and only 23.5 per cent in technology roles", Sustainalytics says.

"However, the company has an ambitious target to have 50 per cent of its US workforce made up of underrepresented groups by 2023."

Post-pandemic, Hale anticipates that investors globally will continue to pour assets into sustainable funds.

"The intermediary and adviser pinch points will be further relaxed, with fewer attempting to wave away interested clients from the idea, and more recommending sustainable investing as an appropriate way to manage risk and promote the common good," he says.

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