Investors are increasingly turning to socially responsible financial strategies such as environmental, social and governance (ESG) investing to ensure environmental and social considerations are accounted for alongside a company’s financial performance.
In fact, triple bottom line investors (who adhere to the idea that businesses should act to further the broader bottom lines of people, planet and profit) have consistently chosen to invest in ESG-focused securities over the past decade, to the point that some experts expect ESG-related assets under management (AUM) to grow to $33.9 trillion by 2026.
For this reason, a basic understanding of what ESG investing is, and the role it could play in your financial strategy, is critical to managing your exposure to long-term risk and ensuring your dollars go to businesses with values that match your own.
What is ESG investing?
Environmental, social and governance criteria are factors that financial professionals can consider when choosing to invest in a particular stock, fund or other financial vehicle:
- Environmental criteria examine how the company manages risks and opportunities in relation to the broader environment, including carbon emissions, deforestation, air emissions and air quality, energy use and conservation, land use, pollution and water usage.
- Social criteria focus on the extent to which the company invests in “people,” reducing risk and providing opportunities in areas such as diversity, equity and inclusion (DEI), health and productivity of workers, fair and sustainable labor practices and customer satisfaction.
- Governance criteria center on leadership and how the business is managed, including executive salaries and compensation, tax practices and financial factors that affect external stakeholders, ethical business practices, board independence and diversity and interactions with various government or regulatory bodies.
ESG investing is the practice of weighing these factors alongside more conventional financial parameters (revenue, leadership, market conditions, etc.) to judge an investment’s financial returns and overall impact.
This practice has grown out of socially responsible investing (SRI), a long-held financial practice with roots as far back as the 18th century that gained momentum in the 1960s during the Vietnam War and has continued to the modern era.
How are ESG scores calculated for different investments?
Figure 1. MSCI's ESG rating scale, taken from https://www.msci.com/our-solutions/esg-investing/esg-ratings.
When looking at investments from an ESG perspective, organizations such as MSCI and Morningstar will look at several factors to calculate an overall “score” based on how well the business adheres to ESG principles.
This practice helps them determine any potential exposure the investment has to ESG risks and how well these businesses manage those risks in comparison to their peers.
Using MSCI’s rating system as an example, analysts will examine material industry ESG risks and opportunities. Then, after determining which ESG criteria are relevant to the industry or sub-industry, analysts will rate the company based on its exposure to those risks relative to their industry peers. A letter grade is assigned between best (AAA) and worst (CCC).
For example, consider two mining companies that are identical when viewed from the perspective of conventional financial analysis.
However, Company 1 has no systems in place to monitor its use of toxic chemicals or pollution. Meanwhile, Company 2 has established operating procedures for reducing its environmental impact and plans for mitigating the effect of an environmental disaster should one occur.
When viewed from an ESG perspective, Company 1 could be rated as CCC to BB due to the risks associated with its environmental impact, such as regulatory fines, social backlash, lower retention of key leadership, contamination of mining sites or civil lawsuits from local communities.Company 2 could likely be rated higher due to its efforts to manage the environmental challenges inherent to the industry.
Should I integrate ESG investing into my financial strategy?
As with all financial decisions, you should take the time to weigh the pros and cons of ESG investing against your financial goals to determine whether investing in ESG companies is the right fit for you.
Advantages of ESG investing
The primary advantage of ESG investing is greater control over how your funds are used. ESG strategies can take different shapes, often centered around a particular area, such as promoting diversity or being especially environmentally conscious. By investing in ESG funds or specific ESG companies, you can direct your money to organizations with missions and values that match your own and avoid any organizations that may run contrary to your personal beliefs.
Disadvantages of ESG investing
ESG investments also carry several potential disadvantages you may want to consider before investing in such securities:
- Higher than average expense ratios — Due to the increased scrutiny placed on the firms included in such funds, ESG funds tend to have slightly higher expense ratios when compared to traditional investments to accommodate the additional research requirements.
- Lack of a single catch-all solution — No single fund or security will reduce your long-term risk and make the world a better place. Instead, you’ll need to choose from various ESG funds that each focus on different goals and ESG criteria.
- Unclear standards for what qualifies as an ESG factor — The Securities and Exchange Commission (SEC) regulates how publicly traded companies report information related to their activities and financial standing. However, ESG risks and opportunities are still up for debate, meaning that most businesses are left to self-report their ESG progress.
- Limited selections may lead to a lack of portfolio diversification — ESG investors have historically avoided verticals such as tobacco, fossil fuels and defense. Combined with the slightly smaller pool of ESG securities to choose from, this means that diversification is somewhat more difficult for portfolios that invest only in ESG funds or organizations.
How to find ESG provider to invest with
When choosing an ESG provider to invest with, you should look for options that emphasize certain qualities:
- More comprehensive perspective of institutional value — The financial advisors who manage these funds are empowered to view the market from different perspectives, giving them a deeper understanding of how businesses might create value over time.
- Emphasis on measurable ESG benefits — High-performing ESG funds will often focus on very specific, measurable benefits produced by a company, as opposed to more ephemeral or yet-to-be-realized aspirations to be more ESG-conscious.
- Sustainable competitive advantage — Look for funds that invest in companies that are both successful and ESG-conscious, rather than funds that prioritize one element over the other. ESG investing is only effective if there is a healthy balance of environmental, social and governance awareness with strong financial fundamentals. The fund should only include organizations that can maintain a sustainable competitive advantage in the marketplace over other competing businesses.
- Potential for returns — Finally, try to choose a fund with a proven history of returns that are in line with or exceed the performance of its benchmark. Determining the opportunity cost you’re willing to pay for investing in an ESG fund is largely up to you, and for many investors a potential loss of a few percentage points over several years is worth the benefit of aligning their investing with their personal values, whereas a loss of a significant portion of their potential growth may lead to dissatisfaction with the fund.
If you’re interested in learning more about ESG strategies and how you can invest in companies that generate measurable ESG benefits, or if you want to speak with a financial advisor, please reach out to us by finding a wealth management team near you.
