In this guide, we’ll look at what ESG investing is and why it has become so popular. At the same time, we’ll go over the fundamentals behind this investment approach and the potential downsides of ESG investing. Finally, we’ll discuss the different ways investors can approach this type of investing.
Environmental, social, and governance (ESG) are the three pillars of an investing strategy that has become mainstream in the financial markets. Retail investors and institutions alike are increasingly considering these three factors when making investment decisions.
Many companies have started to take note and it has become common practice for management to set their own ESG goals. Investors use this (publicly available) information and a company’s respective ESG score to decide whether a company is a good fit for an ESG portfolio.
However, ESG is far from cut and clear as there are different methods to judge a company’s ESG efforts. This, in combination with the existence of several different rating providers, can make it difficult for investors to navigate the world of ESG investing.
In this article, we’ll discuss the ESG principles in-depth and guide you through the process of finding ESG investments that align with your values.
ESG Investing explained
Terms such as sustainable investing, socially responsible investing (SRI), and ethical investing are used interchangeably in the financial markets and there’s a high chance you’ve encountered at least one of them before. These terms are quite general and they differ from ESG investing.
Whereas strategies such as a socially responsible investing focus on excluding certain companies or industries, ESG takes, in addition to exclusion, an opt-in approach. Managers of ESG funds actively look for companies with a high ESG ranking to include them in a fund.
To measure how sustainable or socially responsible companies are, they are measured by a grading system based on ESG. Companies receive an ESG score based on their performance in specific sustainability categories.
ESG focuses on three sustainability factors in particular:
- Environment – This aspect of ESG concerns our planet and its conservation.
- Social – People-related issues, such as employee treatment and customer service.
- Governance – How a company is governed.
The image below shows us a few examples of ESG criteria:
The ESG factors. Source: ecoadvisors.eu
There is no definitive authority on ESG rankings, but there are companies, such as Sustainalytics, that rate companies based on ESG factors. Since there are no universal ESG standards, it’s important to understand how funds and third-party sources screen companies.
Companies with a high ESG score generally prioritize the impact they have on the planet, their stakeholders, and the environment. Growing in importance, ESG issues are top of mind for a growing number of business executives, according to a survey by Harvard Business Review.
Watch the video: How ESG Metrics Work and Why All Investors Should Care
Why is ESG investing becoming more popular?
In 2020, the Forum for Sustainable and Responsible Investment (US SIF) published a report [PDF] indicating that sustainable investment assets had grown by 42% in the period from 2018 to 2020, to $17.1 trillion.
There are several reasons why ESG investing is gaining in popularity. The incentives to invest sustainably can be financial or altruistic, often a combination of both.
Below are listed some of the reasons why investors use ESG criteria for their investments:
ESG investing does not have to come at the expense of high returns. Although long-term data is not available, a growing number of studies indicate that ESG investments outperform their non-ESG peers.
A study by the financial services firm Morningstar found that 41 of their 56 ESG indexes achieved better returns than their non-ESG peers. A potential reason given for this result is that ESG considerations, such as treatment of employees and preventing accidents, could positively impact a company’s financial results.
Strong performance in the environmental, social, and governance categories is connected with value creation in several ways, as shown by a McKinsey report [PDF]. The report states that a high ESG score possibly leads to higher revenue, lower costs, fewer regulatory interventions, higher productivity, and asset optimization.
Below is the performance of top ESG-ranked companies relative to the benchmark:
Top ESG-ranked companies’ performance relative to the benchmark. Source: MSCI ESG Research LLC, Sustainalytics, Refinitiv, Factset.
Investors want to feel good about their investments while achieving good returns at the same time. Aside from making money, investing is increasingly regarded as a way to do good and have a positive impact on the world by purchasing shares of companies that value ESG principles.
A survey by British bank HSBC found that over 90% of the 2,000 participants considered environmental and social issues to be important. The same survey indicated that obstacles to ESG investing had shrunk by 15%.
Since there are many ways to build an ESG portfolio, investors can make their portfolio reflect their values. Given the altruistic nature of many people, this has become an important part of making investment decisions.
#3 Lower Volatility
There is a correlation between ESG companies and low beta, according to research by FactorResearch. A stock’s beta indicates how volatile a company is, with a high beta indicating high volatility and vice versa.
There is no straightforward explanation for this, but companies with low amounts of debt, high profitability, and leaders with a long-term vision are more likely to achieve high ESG scores. As these variables are often linked with low-volatility equities, such as large-cap dividend stocks, they could explain why ESG investments have a low beta.
An example of this lower volatility was displayed during the market crash in March 2020. Although MSCI’s ESG ‘Leaders’ Europe Index dropped sharply, it outperformed the EU index and showed more resiliency during the crash.
On the image below we can see how both indexes fared during the Covid-induced market crash:
MSCI ESG ‘Leaders’ Europe Index outperformed the EU index. Source: FT
The fundamentals behind ESG investing
To understand how ESG scores are created, we need to learn what exactly the score is based on. Each component of ESG investing consists of many different elements that together make up one of the three ESG factors.
The environmental aspect of ESG is the one that has received the most attention as a result of increasing concerns about climate change. Some companies are even accused of neglecting the other aspects of ESG and focusing solely on the E, as reported by Bianchi Public Relations.
To receive a good score for the environmental aspect, a company needs to:
- Have a climate change policy in place;
- Use renewable energy;
- Have a low carbon footprint;
- Have low carbon emissions;
- Use green products;
- Pay attention to water usage and conservation;
- Incentivize employees to use climate-friendly modes of transport;
- Have a good relationship with environmental regulatory bodies.
The social aspect of ESG deals with all issues related to people. This includes all the stakeholders a company has, such as employees, suppliers, shareholders, etc.
To receive a good score for the social aspect, a company needs to:
- Treat and compensate their employees well;
- Have a low turnover rate;
- Focus on training and development of employees;
- Have the right safety policies in place;
- Source supplies in an ethical way;
- Have a company mission;
- Protect consumer rights;
- Have good customer service;
- Have a diverse and inclusive workforce.
The governance aspect concerns everything related to how a company is run. It looks at the effectiveness of upper management, how independent board members are and how ethical a business is.
To receive a good score for the governance aspect, a company needs to:
- Communicate transparently with shareholders;
- Have appropriate term lengths for board members;
- Offer shareholders the ability to choose board members;
- Implement ethical practices;
- Avoid any potential conflicts of interest;
- Have a positive track record regarding lawsuits;
- Separate the roles of chairman and CEO;
- Vote by majority;
- Make sure any executive compensation is connected to long-term value;
- Offer one class of shares.
It’s important to note that there isn’t one authority on ESG ratings. There are several providers of ESG ratings, and each of them acquires data differently. This leads to a variety of methodologies for calculating ESG scores.
ESG rating providers
One of the largest ESG rating providers is MSCI ESG Research. The company uses big data to collect and analyze data on companies. Some of the main areas they focus on are a company’s risk exposure, management practices, a company’s track record on ESG issues and controversies.
Any investor can visit their website and enter the name of an ETF or mutual fund they are interested in. The website then shows the investor a fund’s ESG score, with AAA being the best, and a fund’s performance across the following:
- Carbon intensity;
- Renewable energy usage;
- Corporate governance.
In addition, a fund’s global and peer group ESG ranking is displayed and there is information on the ESG ratings of the individual holdings in a fund. Under “social safeguards screens’’ at the bottom, the percentage of companies in the fund that are flagged for UNGC violations, very severe controversies, controversial weapons, and tobacco is shown.
VanEck Gold Miners ETF ESG rating. Source: MSCI
The Dow Jones Sustainability Index
MSCI ESG Research is not the only ESG reference for investors. The Dow Jones Sustainability Index consists of multiple sustainability indices that track stocks’ ESG performance. There are more than twenty different sustainability indices available, a few examples being:
- Dow Jones Sustainability Asia/Pacific index;
- Dow Jones Sustainability Europe index;
- Dow Jones Sustainability Chile index;
- Dow Jones Sustainability Emerging Markets Index;
- Dow Jones Sustainability Australia Index.
The indices allow investors to apply an ESG investing strategy to particular sectors, regions, or countries. S&P Global, the company behind the Dow Jones Sustainability Index, uses the Corporate Sustainability Assessment [PDF] to evaluate companies’ sustainability practices.
Some indices focus mainly on excluding certain sectors, an example being the Dow Jones Sustainability Eurozone ex Alcohol, Tobacco, Gambling, Armaments & Firearms.
Corporate Sustainability Assessment. Source: S&P Global
The downsides of ESG investing
ESG investing, like any other investing approach, does not come without risks. Here are the most important risks that ESG investors have to keep in mind:
#1 Lack of long-term data
As stated earlier in this article, several studies have shown that ESG investments tend to outperform non-ESG peers. The problem with the data used in those studies is that it’s based on short-term, think of a couple of years, returns.
Since ESG investing only really started to gain popularity after 2006, the year it was mentioned in the UN Principles for Responsible Investment report, there is a lack of long-term data on financial results.
This could negatively impact ESG investments in the long run. If it turns out that they underperform their ESG-peers in the long term, investors, who prioritize returns over ESG principles, might choose to abandon this strategy and invest in non-ESG alternatives instead.
ESG investing has been growing exponentially since 2006. Source: Principles For Responsible Investment
#2 No definitive authority on ESG standards
Funds screen their ESG investments in different ways and, as an investor, it’s crucial to understand how a fund, which you want to buy, screens companies based on ESG criteria.
The varying ways of screening can lead to unexpected or undesired compositions of ESG indices or ETFs.
One might be surprised, for example, that alcohol companies have made an ESG push and are included in several ESG funds. If excluding certain companies or sectors is important to you, it’s advisable to study the methodology and screening process of a fund.
#3 Longevity of ESG prioritization
Given the short track record of ESG investing, it is difficult to predict whether ESG principles will remain an important factor for investors and companies in the future. If ESG investing falls, for whatever reason, out of grace with investors, ESG investments could start to broadly underperform.
Should companies decide to stop prioritizing ESG related issues, a lack of (reliable) sustainability data might ensue. Since firms aren’t obliged to report this data they could choose to stop reporting it, leading to difficulties for investors who apply an ESG approach to investing.
How to approach ESG investing
There are different ways to approach ESG investing. You can choose to create an ESG portfolio yourself or you can use a robo-advisor.
As explained in our guide on robo-investing, this approach is the most hands-off. There has been a steady increase in the number of ESG robo-advisors and it’s now easier than ever to passively invest in a portfolio of ESG funds or companies in a cost-effective way.
With your input, a robo-advisor will select the most appropriate ESG investment for you and manage it independently. It is important, however, to check a robo-advisor’s methodology to make sure potential investments reflect your values. An example of a platform with robo-advisors and ESG funds is the Canadian platform Wealthsimple.
Do it yourself
You can also create an ESG portfolio yourself by picking stocks and funds if you prefer a more active approach to investing. If you choose to do it yourself, there are a couple of things to consider:
#1 Funds or Stocks
The building blocks of your ESG portfolio can be stocks, funds, or a combination thereof. Each type of investment has its ups and downs and finding relevant ESG-related information differs per investment type.
Many companies have started to prioritize ESG principles, so buying individual stocks can make sense for an ESG investor. To find information on a company’s ESG practices, one of the best sources to look at is a company’s impact report. This report discloses the progress a company is making in achieving its ESG goals.
The appeal of investing in individual stocks is the potential of higher returns and aligning investments with personal values can be less complicated with individual stocks than with a fund. The downside of individual stocks is the lack of diversification and the effect the deprioritization of ESG principles by one company might have on one’s portfolio.
These risks can be mitigated by investing in funds, such as ESG ETFs. The number of ESG ETFs has grown quickly and funds with a focus on ESG captured a record $51.1 billion in 2020. To find information on a fund’s ESG score, investors can look up the fund on MSCI ESG Research’s website or look through its prospectus.
The advantage of investing in ESG ETFs is the diversification and the possibility to easily focus on one particular issue that you find important, renewable energy, for example. The downside of investing in ESG ETFs is that funds can potentially contain stocks that don’t align with your values as much as you’d like.
A few popular platforms where ESG stocks and ETFs are available include:
#2 Your Personal ESG Principles
ESG consists of many different factors, but it might not include some that you find important. You might, for example, want to exclude marijuana companies from your portfolio. Many ESG funds have marijuana stocks in them, so it will take some additional screening on the investor’s part to filter out funds with marijuana stocks.
It’s important to make sure a fund aligns with your values even when they fall outside of ESG criteria. Everyone has different values, so it’s important to consider whether ESG entails your values before buying a stock or fund with a high ESG score.
ESG investing has increased in popularity due to the positive financial performance of ESG investments and the altruistic nature that exists in many individuals, among other factors. The relatively low volatility is also an appealing factor to investors with lower risk tolerance.
The ESG principles include many different aspects and each investor will have to look closely at the methodology and screening process of a fund or ESG ratings provider to ensure that it matches personal values and beliefs.
Due to the relatively short track record of ESG investing, investors have to take several risks into account. The lack of long-term data on financial performance and the fact that companies could deprioritize ESG principles in the future are risks that can’t be overlooked.
After the decision to apply an ESG approach to investing has been made, an investor has the choice between individual stocks and funds, or a combination. The growing number of ESG-themed ETFs and the increasing number of companies that emphasize ESG principles gives investors a lot to choose from.
FAQs about ESG investing
What Is ESG Investing?
ESG investing is an approach to investing that prioritizes the sustainability of investments, namely the following three aspects:
- Environmental – Issues related to our planet, such as climate change;
- Social – People-related issues, such as employee treatment;
- Governance – The way a company is run.
How are ESG scores calculated?
There isn’t one definitive authority on ESG standards. Rather, there are several companies, using different methodologies, that provide ESG scores. The ESG indicators used by ratings providers may differ per company, but investors can usually find in-depth information on a provider’s website.
Ratings providers also obtain information in varying ways. Some acquire data from public databases, where others use questionnaires that let companies report data on their ESG progress themselves. Some of the largest ESG ratings providers are:
How can I invest in ESG investments?
There are several ways an investor can create an ESG portfolio. A passive approach is to use a robo-advisor, which will choose the right investments for you and manage them. More active investors might prefer to choose individual stocks, requiring a more hands-on approach. As ESG ETFs and mutual funds have grown in number, this has also become a popular way to conveniently create a well-diversified ESG portfolio.
Are ESG and SRI the same?
Given that terms such as sustainable investing, socially responsible investing (SRI), and ethical investing are used interchangeably, it’s not surprising that investors might confuse ESG with other types of sustainable investing. SRI is different in that it uses an exclusionary-only approach, excluding certain stocks and sectors. In contrast, ESG takes an opt-in approach in addition to excluding stocks and funds with low ESG scores.