While most investors have various objectives in mind when making financial decisions—such as long-term growth and/or future retirement income—there are some cases where an underlying company or fund goes against an individual’s beliefs. In these instances, even if the investment vehicle has performed well over time, the investor may decide not to include such items in their portfolio. That is where ESG investing could provide a viable solution.
What Is ESG Investing?
ESG stands for Environmental, Social, and Governance. Investors who employ an ESG strategy are using these factors to analyze stocks, mutual funds, and other avenues of investment.
This type of “socially responsible investing” (as it is often called) has gained a great deal of traction over the past couple of decades as investors strive to not only grow and protect their money, but also to help shape (or reshape) the world.
Including these non-monetary criteria in a portfolio mix was once considered somewhat radical. However, this type of investing is not only more attainable today, but it could also be more profitable. One reason for this is because consideration for environmental, social, and governance issues have evolved a great deal from its original concept of screening out equities on the basis of moral values.
There are currently a number of different methods that investors and financial professionals use to select investments that are based on a wide variety of different values. While ESG issues are not typically addressed by publicly held companies, there is a growing number of businesses and other entities that are starting to do so by providing disclosures in their annual reports, or as a part of their stand-alone sustainability reporting.
In addition, there are various financial entities—including the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD)—that are starting to form standards and define materiality in order to incorporate these and other factors into the overall investment process.
According to a 2019 survey by a large asset-management firm, approximately 85 percent of individual investors are interested in sustainable investing—a figure that is up from 75 percent in 2017.
There are also more financial options available now for investors in the area of ESG and socially responsible investing. For instance, based on Morningstar research, there were only 111 sustainable open-ended mutual funds and exchange traded funds (ETFs) in 2014, but as of 2019, this figure has nearly tripled to over 300.
What Makes ESG Investing Different?
ESG and socially responsible investing is different because it not only strives to generate financial returns for an investor, but also to generate ethical, social, environmental, and governmental changes.
Therefore, investors who take on an ESG type of strategy select financial vehicles for their portfolio based on performance and expenses, as well as on whether or not the revenue from a company aligns with their values.
As the demand for ESG investing is accelerating, there are some key issues that are starting to emerge, such as:
• Climate change
• Social unrest
• Interconnectedness of sustainability and the overall financial system
• Scarcity of a natural resource (such as fresh, natural water)
• Changing demographics
It is important to keep in mind, though, that there isn’t one single, exhaustive list of ESG issues. Rather, they can typically be interlinked—and because of this, it can be somewhat challenging to sort out which investment options are “only” environmental, social, or governmental.
Investors and financial advisors will often use six methods for taking ESG factors into consideration. These can include one or more of the following criteria (which are not necessarily mutually exclusive):
• Exclusionary screening
• Best-in-class selection
• Thematic investing
• Active ownership
• Impact investing
• ESG integration
What About ESG Investment Returns?
In the past, environmentally and socially conscious investments were considered more risky than other more traditional options. But that assumption has since changed. A recent analysis by a global asset-management firm found that 80 percent of the reviewed studies showed that sustainability practices actually have a positive influence on the performance of investments. And further research determined that not only can the performance of mutual funds with an ESG bent match that of more traditional funds, but in some cases these investments can perform even better.
Is ESG Investing Right for You?
With so many different ESG investment opportunities available today, it can be difficult to sort them all out. Outlining what is most important to you can be helpful, though. For instance, are you against companies that manufacture firearms, or are you more interested in businesses that are run by female CEOs?
It is also important to determine how much of your portfolio you want to have allocated toward this type of investing. So before you move forward with any ESG investment strategy, it is recommended that you discuss your short- and long-term objectives with a CERTIFIED FINANCIAL PLANNERTM, practitioner who is well-versed in this type of investing. That way, you will be better able to narrow down which ESG investments, if any, are right for you.
This article appears in the January 2021 edition of OutSmart magazine.