ESG Investing: Environmental, Social, and Governance Fully Explained

ESG Investing

Causes like protecting the environment or promoting social equality haven’t always been factors considered when evaluating investments. But an approach to investing called environmental, social, and governance investing, or ESG, is changing that. You might hear other terms used for ESG investing like socially responsible investing, sustainable investing, values-based investing, and impact investing.

What these terms have in common is that they describe an approach to evaluating investments based not just on traditional measures of financial risk and return, but also by factoring in their effect on society and the world. This may include selecting investments based on a company’s environmental impact like pollution and animal welfare, a social impact like human rights or fair compensation, and governance factors such as having a diverse workforce, executive team, or corporate board.

However, ESG investing is about more than just investing with a clear conscience. Some investors believe that companies with high ESG ratings have the potential to outperform those that do not. This idea of “profit with principles” is gaining popularity.

sustainable fund inflows and total assets graph

For example, money invested in ESG-related funds rose 53% globally in 2021 to $2.7 trillion. But is it possible to invest responsibly without sacrificing performance?

Let’s look at how ESG investing works and the performance of ESG investments over time

But keep in mind that past performance is not a guarantee of future results or investing success. While some individual investors may pick their own stocks based on ESG criteria, many invest in funds or other investment vehicles that incorporate ESG factors in their investment strategy.

Managers of ESG investing products commonly use two strategies for selecting investments: exclusionary and inclusionary. The exclusionary approach typically avoids industries that don’t meet certain criteria or standards.

For example, a fund employing an exclusionary approach may include all the companies from a major stock index except for those in the oil, mining, and tobacco industries.

An inclusionary strategy may involve seeking out companies that engage in what is considered to be positive ESG business practices by doing things like developing renewable energy or promoting equal opportunity employment and diverse management.

This approach tends to look at companies’ impact more holistically and overlook shortcomings in one area in favor of strengths in other areas. For example, an investor may be surprised to find a tobacco company in an ESG fund. But if the company is part of an emerging market and makes significant investments to develop rural communities, it may be selected using an inclusionary approach.

So, how do individual investors or managers of ESG investment products decide which companies should be included or excluded from their ESG investing strategy?

There are many investment research and analysis groups that evaluate and rate companies based on their ESG business practices. Many investment advisers have developed their own screening criteria as well. These evaluation methods and resulting ratings draw from a variety of sources including company disclosures, executive engagement, public records, proprietary research, and artificial intelligence.

Some may focus more on environmental issues while others specialize in corporate governance. Other groups may rank in all areas, but apply different weightings to each characteristic. Individual investors or investment managers can choose to use these ratings as part of their analysis to determine if a company’s investment meets its ESG investing strategy criteria.

However, there are a few issues with the rating systems investors should be aware of. First, some of the data used may be inconsistent because some information used by analysts is self-reported by companies, and some don’t report at all. This means companies may be able to hide information and practices that could result in an inaccurate or misleading rating.

Second, rating criteria can be inconsistent, which can make it difficult to directly compare products. For example, some ratings focus more on corporate governance while others focus on the environment. And when it comes to ESG investment products, managers may each also use different criteria based on their stated investment strategy.

For example, some ESG products may seek to provide risk and returns similar to a broad market index. But in order to do that, the product may still need exposure to every industry in its benchmark, even industries with low ESG ratings overall.

For example, an oil company with a relatively low ESG rating could still be included if it’s the highest-rated company in its industry. This variety of ESG strategies can make it difficult to answer one of the biggest questions:

How does the ESG approach to investing actually perform relative to non-ESG investment approaches?

While it’s hard to provide a definitive answer, there are numerous studies that can help paint a picture of how the ESG approach to investing has performed. In looking at these studies, the results indicate there may be little performance sacrifice for the ESG approach to investing, and some potential for risk reduction.

ESG and financial performance chart

A 2021 meta-analysis found a positive correlation between a company’s financial and investment performance and its ESG business practices. The results suggest that companies with positive ESG business practices often had better financial performance over a longer time frame, provided some protection against social and economic crises, had better risk management, and more.

Average ESG fund morningstar category percentile rank graph

Charles Schwab’s research found that, generally, funds employing an ESG investing approach as a whole have fairly similar return and risk characteristics when compared to non-ESG funds with similar assets. One common critique of ESG strategies is the lack of diversification.

For example, some equity ESG strategies may be heavily weighted in technology stocks because they tend to use fewer natural resources. Historically, technology stocks have experienced higher volatility and risk. An ESG strategy that is overweighted on technology may also experience greater volatility.

Additionally, some ESG strategies may favor large corporations, which often have more resources to devote to ESG practices like supporting social causes or purchasing carbon offsets.

So, when thinking about employing an ESG investment approach, what factors should you consider?

First, determine which investment product is best suited to your needs and goals. Common products include individual stocks, funds, and separately managed accounts. For example, selecting individual stocks may give you more control over which criteria you use to select companies, but it may also require more research on your part.

Second, do some homework to determine which ESG characteristics and criteria matter most to you. You can research the methods used by various ESG rating providers or, if you’re considering an ESG product, like a fund or separately managed account, read the prospectus or offering documents to understand its objectives, philosophy, and screening criteria and methods.

Third, be mindful of expenses. As with any investing strategy, higher fees can eat into returns. If you’re considering ESG funds, keep in mind that actively-managed funds generally tend to have higher fees, while passively managed index funds tend to have lower fees.

Make sure to read the prospectus to understand the fees and how they may impact performance. If you’re part of the growing number of investors considering expressing their personal values in selecting their investments, understanding what an ESG investment approach is and how ESG investments have performed can help you make more informed decisions.

DISCLAIMERS: Any information or advice available on this channel is intended for educational and general guidance only.

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