It seems like it’s nearly every day that you hear about another company that supports causes you oppose. In the wake of the news, it can be tempting to want to pull your investments from the mainstream mess and run. Your investment portfolio may keep you up at night from time to time, but it shouldn’t be due to worrying about the ethics of the companies you’ve invested in.
If any of this hits home for you, you’re in luck. There is a significant number of people who want to invest in a way that reflects their values. Enter: ESG investing.
In this article, we’ll discuss what ESG investing is and what your options are to begin investing in a way that looks beyond profit alone.
ESG Defined
ESG stands for Environmental, Social, and Governance. At its core, ESG investing is simply the consideration of Environmental, Social and Governance (ESG) factors in the investment decision-making process.
An ESG rating system assigns a score to a company based on how well it does in each of the three categories, which investors can use to make more informed decisions about where to put their money. For example, considerations might include a company’s carbon emissions, employee diversity, or its policies around boardroom diversity.
A company’s financial health and performance have long been the primary guides by which investors make investment decisions. However, ESG ratings introduce a way to include values-based factors in your investment decision-making, leading to what some investors refer to as a “double bottom line” of financial returns and social impact.
The Origins of ESG Investing
The roots of ESG investing lie in the values-based investing movement of the 1970s. At this time, many investors were becoming increasingly enlightened to the role that business played in society. People were beginning to see how their investment dollars could effect change, or at least not cause harm.
The first mutual fund to launch with an explicit social purpose was the Pax World Fund in 1971. The fund, which is still in operation today, was created in response to the Vietnam War. It was one of the first funds to screen out companies that did business in Vietnam, and it also avoided investments in companies that produced weapons.
From there, the field of values-based investing took off. Several other funds were created in the 1980s and 1990s with explicit social or environmental missions. The Domini 400 Social Index, for example, was launched in 1990 and tracks the performance of 400 companies that meet specific social and environmental criteria.
The growth of ESG investing continues to this day, with 33% of U.S. assets under professional management being invested in companies that adhere to ESG standards.
Dissecting ESG Ratings
As shared earlier, the three areas that companies are rated on when it comes to ESG are environment, social, and governance. ESG rating agencies will review a company’s business practices to assign a score. We’re going to dive into the details of each scoring category so you can cut through the noise and focus in on the factors that matter to you.
Environmental
If you like the idea of backing companies that are doing their part to protect the environment, then paying attention to a company’s environmental score is an excellent place to start. ESG rating agencies are likely to evaluate companies based on factors like their carbon emissions, water usage, waste production, and the overall impact the company’s business practices have on the planet.
Social
The social category of ESG ratings considers how a company treats its employees, suppliers, customers, other stakeholders, and humanity in general.
Regarding employee relations, things like diversity and inclusion, health and safety standards, and compensation and benefits are all likely to be considered. Regarding customer relations, ESG agencies might evaluate a company’s marketing practices or how they handle customer complaints. Of course, there are also much more dire concerns, such as human exploitation, which might come into play if a company is found to be using child labor or engaging in other unethical practices.
Governance
Last but not least, we have governance, which may be the most nebulous of the three categories, as it can encompass many different things. In general, it refers to the way a company is managed and the processes that are in place to ensure accountability.
Some things that might be considered under this category include a company’s board structure, executive compensation, and shareholder rights. Additionally, the rating agency might evaluate a company on its transparency and disclosure practices and any ethical breaches that have occurred.
What Is ESG Investing and How Does It Work?
We understand that ESG investing is a way for you to support companies that share your values. But what does that mean in practice? And how can you get started with ESG investing?
In general, there are two main ways to approach ESG investing. The first is through negative screening, which is when you avoid investments in companies that engage in activities that are contrary to your values. For example, if you’re interested in environmental sustainability, you might choose to avoid investments in companies that are involved in oil and gas production.
The second way to approach ESG investing is through positive screening, when you seek out investments in companies that are leaders in environmental, social, and governance practices. This can be a more proactive approach, as it allows you to support the companies you believe are making a positive impact.
ESG Investment Fund Options
When it comes to actually investing, there are a few different options available. One is to invest in individual stocks, which allows you to research each company and make investment decisions accordingly. The other option is to invest in mutual funds or exchange-traded funds (ETFs) that focus on companies with strong ESG practices.
ESG Stocks vs. ESG Mutual Funds and ETFs
Before we get into the nitty-gritty of the differences between the various investment options, we have to address the elephant in the room. There is no guarantee that a company with good ESG practices will outperform unfavorable ones. However, studies have shown that companies with strong ESG practices tend to be more financially successful in the long run. As an investor, you’ll get to decide how much importance you place on ESG ratings.
Now that we’ve addressed that, let’s take a closer look at each investment option!
Individual ESG Stocks
When you invest in individual stocks, you select the specific companies you want to invest in. This gives you a lot of control over your investment portfolio, but it also requires a significant amount of research. You’ll need to understand each company’s ESG practices and determine whether they align with your values.
Selecting individual stocks can be a more hands-on approach that allows you deep insight into the companies in your portfolio, but it also requires a lot of time and effort to gain those insights.
If you are an active investor who likes a lot of control over your portfolio and is willing to put in the time to research each company, you may prefer investing in individual ESG stocks.
ESG Mutual Funds and ETFs
If you’re looking for a more passive approach, investing in ESG mutual funds or ETFs might be a good option for you. With these investment options, you don’t have to worry about researching each individual company. Instead, you can rely on the fund manager to select companies that meet the fund’s ESG criteria.
For example, if you’re investing in an environmental sustainability ETF, the fund manager will only invest in companies that are leaders in environmental practices. This can simplify the investment process, but it also means that you have less control over the individual companies in your portfolio.
If you want a more passive approach or don’t have the time to research each individual company, investing in ESG mutual funds or ETFs may be more comfortable for you.
The Role of ESG Rating Agencies
Now that we’ve gone over what ESG investing is and how companies are rated let’s briefly look at the organizations that do the rating.
ESG rating agencies are responsible for assessing a company’s environmental, social, and governance practices and giving them a score for investors to base their decisions upon. These agencies use a variety of different methods to come to their conclusions, but they all share the common goal of providing investors with valuable information that can help them make informed decisions.
One of the most popular ESG rating agencies is MSCI, which rates more than 7,000 companies across 60 different countries. Other well-known rating agencies include Sustainalytics, Governance Metrics International, and FTSE Russell.
Each of these organizations has its own unique methodology, so it can be helpful to understand how they operate before relying too heavily on their ratings. That being said, they can all be valuable resources for information about the ESG practices of the companies you’re thinking about investing in.
It’s also worth noting that some companies might choose to proactively disclose their ESG practices and policies, even if they are not required to do so. This is generally seen as a good sign, as it indicates that the company is committed to being open and transparent about its operations.
Calculating ESG Scores
ESG scores are calculated using a variety of different factors. Just for fun, let’s outline a handful to drive home the idea!
Factors that determine a company’s ESG score include the companies:
- emissions
- energy use
- water consumption
- waste production
- safety record
- employee relations
- customer satisfaction
- supplier management
- board diversity
- executive compensation
- accounting practices
Once these factors, and in some cases many more, are evaluated, the ESG rating agency will give the company a score. These scores are generally expressed as either a number ranging from 0-100, with higher scores indicating higher marks. Others may use a scale of A to C, with AAA being the best and CCC being the worst.
Each rating agency has its own unique methodology, so a company’s score from one agency might not match up perfectly with its score from another. However, this is no cause for alarm, as the ratings are meant to give you a general idea of how well a company is doing from an ESG perspective. Consider the rating to be a guide rather than a rule.
Pros and Cons of ESG Standards
Now that you’re an expert on the practice of ESG investing let’s take a look at some of the pros and cons of this type of investing so you can determine to what extent you’d like to utilize these factors in your investment strategy.
Pros
- Divert funds from unethical organizations
- Reward companies for employing positive principles
- Support causes you care about
- Align your investments with your values to the degree you choose
- Diversify your portfolio to companies you may not otherwise have found
- Discover companies you may want to patronize
Cons
- Potential effects of government intervention on the free market
- ESG funds don’t usually outperform the broader market
- ESG criteria exclude entire industries and reduce portfolio diversification
How to Start Building Your ESG Investment Portfolio
Some investment decisions take significant strategy to put into motion. When it comes to ESG investing, though, you get to choose to what extent you factor the ratings into your investments. Still, there are a few steps you should take when you’re ready to begin building your portfolio.
- Seek professional financial guidance- Before making any investment, it’s always a good idea to seek professional financial guidance. This is especially true if you’re new to investing or if you have questions about how to factor ESG criteria into your investment strategy.
- Define your values and ESG priorities- Not all ESG factors are created equal. Some investors may prioritize environmental factors, while others may focus on social issues. It’s important to take some time to figure out which of these categories is most important to you so you can make investment choices that reflect your values.
- Pick your approach- As we discussed earlier, there is positive screening and negative screening for ESG investment options. With positive screening, you only invest in companies that meet certain ESG criteria. With negative screening, you avoid companies working in industries or with practices that don’t fit with your values. You’ll need to decide to what extent you wish to incorporate ESG ratings into your investment decision.
- Take time to research investment opportunities- Take some time to research specific companies and investment opportunities. ESG investing is a type of responsible investing that considers environmental, social, and governance factors when making investment decisions.
- Meet with a financial advisor. An advisor will be able to bring things to your attention you may not have considered – such as tax implications and proper diversification.
The Bottom Line
Whether or not to incorporate ESG standards into your investment strategy is a personal decision. Some people feel passionate about only investing in companies whose business practices align with their values, while others believe that the free market should decide which companies succeed or fail. No matter where you fall on this spectrum, the choice is yours.
If you’re interested in incorporating ESG criteria into your investment strategy, the team at Dechtman Wealth Management can help. We have years of experience helping clients build portfolios that reflect their personal values. Contact us today to learn more!
