Making the world a better place – who would not want to contribute to that? Knowing that the actions we take today will benefit generations to come goes a long way. Whether it be through reducing our carbon footprint or advocating for equal pay, most can agree on the common value of doing better for the longevity of this world. This is where environmental, social, and governance investing, more popularly known as ESG investing, comes into play. By partaking in this investing philosophy, one is aligning their investments with their core principles and values, chiefly for the enhancement of society and the greater world.
Dissecting the acronym
As previously stated, ESG investing looks at three main factors: the environment, the social element, and corporate governance. When evaluating the “E” – the environmental component, one may consider what future energy source may be prevalent – wind, solar, or coal? Under the social aspect, the “S,” the investor may research how the company’s culture affects its employees and the greater society. For corporate governance, the investor may evaluate how management’s interests are aligned with business performance, making sure they do not end up investing in the next Enron. Together, ESG factors can provide clarity into a company’s risk profile, quality, and culture that may have a material impact on earnings.
Below are some of the common themes that are prevalent when assessing each factor:
- Environmental: climate change, carbon footprint, waste production, energy consumption, and renewable energy.
- Social: company culture, health and safety, employee relations, diversity and inclusion, pay equality, and community involvement.
- Governance: executive compensation, shareholder transparency, board of director independence, management’s effectiveness, and conflicts of interest.
What makes ESG Investing different?
Some will contend that ESG investing is nothing new. In fact, there is a partial truth to that. Dating back to the 1970’s something called Socially Responsible Investing, or SRI, proliferated as investors started to reward companies that did not inherently focus on short-term profits at the expense of long-term growth. Under the SRI umbrella, investors used exclusionary screens, opting out of investments tied to specific industries such as alcohol, tobacco, gambling, or weapons. By using these screens, investors exclude what goes against their values and are left with stocks that are acceptable to invest in.
Where ESG diverges is in its more broad-based approach focused on identifying companies that do good with explicit inclusion, and not exclusion, of environmental, social, and governance factors. Still, these differences tend to get clouded within the financial industry due to the varying viewpoints individuals have on ESG factors. What is important to understand is that ESG investing offers investors the ability to invest based on their own core principles and values while making a positive impact on this world.
Often times, investors assume that adding this increased level of scrutiny associated with ESG factoring when evaluating a company limits what they can invest in. While it is true that some existing ESG funds exclude certain industries or companies, there does not need to be a wholesale exclusion of these areas upon performing individual company research. Everyone views the world through a different lens and what may be important to one individual may carry a different weighting among others.
Furthermore, investors tend to associate the exclusionary myth with a decrease in performance. However, it is incorrect to deduce that all ESG funds will underperform the broader market. In fact, some research points out that by integrating ESG factoring with traditional fundamental analysis and portfolio construction, one may be able to reduce portfolio risk and enhance financial performance. Think about it this way. If a company actively seeks to address ESG factors such as climate change, they are mitigating future risk to the company’s operations and profits. Thus, the companies that have a focus on how ESG risks may affect their continued operation and earnings potential stand to benefit over the long-term.
Challenging the challenge
Despite the growing investor appetite for ethical investing, the number of companies providing color into their initiatives or incorporating ESG metrics is limited. This leaves the investor with two options. The first option is for the investor to do their own homework on the company, but they may be restrained by the lack of publicly available information. Thankfully the push for this investing philosophy has made some companies adopt new standards. Take Amazon, for example, which now has a department devoted to ESG factors – something they did not have five years ago.
The other option investors have is investing in an ESG fund. Nevertheless, the challenge that exists with this comes from the lack of effective comparisons among the ESG funds. With these funds still in their infancy, measuring performance or matching the fund’s goals with the investor’s values can be difficult. Fund managers employ different methodologies, weighing various factors differently. However, in an effort to address this problem, database providers Sustainalytics, Morningstar, and MSCI have started assigning an ESG score ranking to various funds as well as individual companies.
How can you get involved?
Though growing in popularity, ESG investing is still in the early innings. With that said, accessibility for this investment style is growing at a somewhat rapid pace. Of course, individual stock analysis centered around the three factors could yield investment decisions; however, an increasing number of mutual and exchange-traded funds targeting these sustainable practices are available on the market. Before investing in ESG funds, it is imperative to examine the respective fund’s framework and compare its underlying goals with your core values and principles. Ultimately, one should look first and foremost at a fund that aims to outperform the market while also considering all of the ESG-related risks tied to the companies in its underlying portfolio. For further insight into ESG investing and to see how you can get involved, make sure to reach out to your investment advisor.