What Is ESG Investing?
ESG is short for environmental, social and governance. ESG investing is a term used to describe investment strategies that focus on these factors. This type of investing entails buying the debt and/or equity of companies that embrace sustainable practices and exhibit ethical behavior across the ESG spectrum. At a high level, these companies are characterized as follows.
Characteristics of ESG Investing
- Environmentally inclined companies that work to conserve the natural world and avoid activities that harm it.
- Socially inclined companies that make a concerted effort to treat all people (internal and external stakeholders) with decency and respect while maintaining policies that foster inclusivity and diversity.
- Governance focused companies that maintain a highly organized and responsive system to manage their operations in an ethical, legally compliant and risk-minded fashion.
What Is the Rationale?
The rationale for ESG investing is that companies that exhibit environmentally conscious behavior are vital to the preservation of our planet. Moreover, companies that thoughtfully serve all stakeholders are positioned to outperform less engaged and/or socially irresponsible firms. For ESG investors, the collective result is a sustainable environment and a stronger society, along with a financial reward to their personal finances.
In theory, this is all very plausible. Unfortunately, there are conflicting viewpoints on the concept of sustainability, and there’s a lot of ambiguity associated with how to implement an ESG investment strategy. Various institutions, including the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD), are working to bring some uniformity and objectivity to the space, but the criteria used to evaluate investments continues to vary widely.
Historical Context
The notion of sustainable investing is not new. Religious and ethical beliefs have been influencing investment decisions all over the world for hundreds of years. However, contemporary approaches to ESG investing are relatively immature.
Focused ESG considerations didn’t enter the mainstream consciousness until 2006, following the release of the United Nations’ Principles for Responsible Investments (PRI). Essentially, this a set of guidelines for incorporating ESG factors into business policy and strategy. Today, with nearly 4,000 signatories (responsible for managing over $150 trillion of assets), it is widely considered the foundational reference for ESG investing.
Since the introduction of the PRI, ESG investing has grown considerably, but the uptake has been especially significant in recent years. This is attributable to a multitude of factors, including those described below.
Growth Factors for ESG Investing
- Broader awareness of social, labor and human right issues and risk across the globe due to the growing complexity of supply chains.
- Concerns around climate change due to the increasingly frequent and catastrophic storms.
- Larger proportion of younger individuals and women in the investing population, both of which tend to exhibit a heightened level of engagement regarding environmental and social issues.
The collective result has been a rapid increase in the monetary value of ESG strategies. According to a January 2022 report by Bloomberg, global ESG assets under management grew to $35 trillion in 2020, a 52% increase since the $23 trillion reported in 2016. By the end of 2022, the total is projected to reach $41 trillion.
Socially Responsible Investing vs. ESG Investing vs. Impact Investing
Before we delve further into ESG investing, let’s take a step back and visit the broader concept of sustainable investing. Over the years, it has evolved across three distinct segments — socially responsible investing, ESG investing and impact investing.
Socially responsible investing (SRI) entails an exclusionary approach, where companies deemed unethical, harmful or otherwise undesirable are filtered out of the investment opportunity set. Types of companies that are typically screened are those that deal in alcohol, tobacco, weapons and gambling. SRI is the simplest and least expensive form of sustainable investing.
ESG investing entails an inclusionary approach, focusing on companies that actively work to limit their negative societal impact and/or deliver meaningful benefits. As the space continues to evolve, there is a growing emphasis on standardizing the ways companies evaluate and prioritize ESG criteria. An example of an ESG investment is a real estate company that spearheads redevelopment projects in disadvantaged communities through renewable energy technologies.
Lastly, impact investing is more personalized than SRI and ESG investing. It reflects a direct link between an investor’s values and the utilization of his or her capital. Investments are only made in companies and causes that clearly support the resolution of societal problems that interest the investor.
Impact investing is typically associated with privately held assets, while SRI and ESG investing generally relate to publicly traded assets.
As a result, with impacting investing, there is less focus on returns and more focus on making a difference. Impact investors rally behind causes like the elimination of poverty, the advancement of green energy initiatives and the purification of water in emerging markets.
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How Does ESG Investing Work?
There is no standardized method to evaluating a company’s sustainability; all frameworks exhibit some degree of subjectivity. But the process of establishing an ESG strategy is simple. A high-level explanation — in the context of a new, fund-style vehicle — is outlined below.
5 Steps to Establishing an ESG Strategy
- The ESG fund provider establishes and articulates an overarching ESG investing style, objectives and parameters.
- Next, the fund provider specifically identifies the various ESG factors to incorporate into its evaluation framework. It also establishes a weighting scheme for the factors and determines how individual scores are to be determined.
- Then, the provider markets the fund to investors, transparently communicating the structural details noted above. If successful, the provider will hit its fundraising goal.
- At this stage, the provider invests the cash in companies that achieve high ESG scores. At the same time, the provider strives to maintain an appropriate level of diversification and ensure compliance with specified guidelines.
- Over time, the provider distributes recurring reports to convey the fund’s financial performance and disclose details on how well it is being managed based on its ESG objectives.
Benefits of ESG Investing
The benefits of ESG investing are potentially huge, but largely anecdotal at this stage. In theory, sustainable investing bodes well for the future of our society, but we need more time to establish standardized approaches and objectively evaluate the results.
- Healthier and More Sustainable World
- At its core, ESG investing holds the promise of helping to solve the environmental and social problems of the world while encouraging companies to focus more on maintaining governance practices that benefit all people.
- Higher Returns
- The financial rationale for ESG investing is that proactive, environmentally and socially minded companies are vital to the future of our society. And over the long term, they will outperform companies that do not exhibit a focus on sustainability.
- Lower Risk
- Alongside the potential for higher returns, diversified ESG investing is also viewed as a way to lower your risk. The thought is that ESG investments hold up better during catastrophic events and turbulent markets, and they are better managed and less prone to fraud and corruption.
Potential Long-Term Benefits of ESG Investing
How Do I Start ESG Investing?
If you want to embrace ESG investing, the first thing to do is decide whether to manually establish an ESG portfolio or invest in a fund-style vehicle that satisfies your objectives. Unless you’re an experienced securities analyst that is well versed on the evolving ESG space and has plenty of free time, the do-it-yourself approach is not recommended. The fund route is less time-consuming, cheaper and much easier to implement in a diversified manner.
The number of ESG funds has surged in recent years. So, you have a lot of options at your disposal. According to Morningstar data, there were 534 open-end and exchange-traded funds at the end of 2021. This is five times the number available a decade ago and three times the number available five years ago.
Some of these funds focus on a particular ESG issue, such as green energy or organic farming. Others are more diversified, embracing a variety of ESG objectives. Ultimately, fund-style investing makes it relatively easy to target whatever area of sustainable investing you favor, as narrowly or as broadly as you like. The best brokerage firms offer fund screening tools to aid your search and comparison efforts.
More Hands-on Assistance
If the self-service concept makes you uncomfortable, you may want to enlist the help of a robo-advisor. This entails a modest cost, but you’ll benefit from expert-level research and automated investment management. ESG guidelines vary from one robo-advisor to the next, but you’ll be in good hands with one of the following solutions: Betterment, Earthfolio, Ellevest, OpenInvest, Sustainfolio and Wealthsimple.
Instead of a robo-advisor, you may want to enlist the help of a full-service financial advisor that has expertise in the ESG space. This type of advisor can establish a detailed and highly personalized financial plan for you. The human connection is likely to yield a more robust outcome than what is achievable via a robo-advisor, but it comes at a much higher cost.
Popular ESG Funds
If you pursue the fund approach — whether through self-directed screening tools, a robo-advisor or a full-service financial advisor — keep the funds noted below on your radar. They are among the largest and most diversified ESG funds in the market. All are relatively low-cost and sensible for new ESG investors.
- Parnassus Core Equity Fund Investor Shares (PRBLX)
- Launched in 1992, this $27 billion fund is actively managed and invests in high-quality, large-cap companies with the goal of reducing downside risk during market declines. It focuses on companies with long-term competitive advantages, relevancy and quality management teams. It has an annual expense ratio of 0.82%.
- iShares ESG Aware MSCI USA ETF (ESGU)
- Launched in 2016, this $23 billion exchange-traded fund seeks to track the investment results of an index of large- and mid-cap U.S. companies that have positive ESG characteristics while exhibiting risk and return characteristics similar to those of the broader MSCI USA Index. It has an annual expense ratio of 0.15%.
- Vanguard FTSE Social Index Fund Admiral (VFTAX)
- Launched in 2019, this $13 billion index fund seeks to replicate the performance of the FTSE4Good U.S. Select Index, which reflects large- and mid-cap stocks that have been screened for certain ESG criteria. It has an annual expense ratio of 0.14%.
Top ESG Funds
Frequently Asked Questions About ESG Investing
Investing in sustainable funds that prioritize ESG goals is theoretically sound. These investments hold the promise of improving our society. Unfortunately, the track record of ESG investments is largely unproven due to the range of inconsistent and subjective approaches to implementing and measuring ESG strategies.
The ultimate value of ESG investing depends on whether an investment strategy encourages companies to drive real change for the common good or merely check compliance boxes. That, in turn, will depend on whether ESG investment dollars follow criteria that are realistic, measurable and actionable. Hopefully, the ongoing work by organizations such as the SASB, the GRI and the TCFD will help drive this outcome.
It is unknown if ESG investing will limit your performance, largely due to the ambiguity and lack of objectivity associated with many ESG investing strategies. While ESG investing is undeniably hot, it’s unrealistic to assume it will prove to be better than unrestricted approaches to investing. At this stage, any evidence suggesting otherwise is largely anecdotal. More time is needed to extract objective data points over several different market environments.
ESG score calculations vary from one investment company to the next. Most companies embrace a framework that begins with an extensive listing of the environmental, social and governance factors to track. Then, a weighting scheme is established to prioritize the various factors, and a process for measuring each factor is established.
Then, everything on the radar is evaluated and aggregated, which facilitates portfolio buy-and-sell decisions. The best ESG strategies provide transparency into all of this, offering investors a clear understanding of their holdings.
