Investors consider a number of different factors when evaluating different investment opportunities. This may include, for example, the level of risk associated with a particular asset, the potential return or the associated costs and fees. But many investors are now adding sustainability as a requirement before investing their money in a particular asset.
In recent years, ESG investing has grown in popularity – and companies are taking notice.A report from MorningStarfound that the number of sustainable open-end and exchange-traded funds available to US investors increased to 534 in 2021, a 36% increase from 2020.
“ESG investing is a process that focuses on long-term risks ignored by traditional Wall Street analysis,” said Blaine Townsend, CIMA™ and executive vice president and director of the Sustainable, Responsible and Impact Investing Group at Bailard, Inc. . and investment management firm in the Bay Area. “Consider climate change, the scarcity of natural resources or a toxic management culture that does not allow a company to compete for the most talented employees.”
What is ESG investing?
ESG stands for “environmental, social and governance”; it is a form of investment strategy for those who want to invest their money in sustainable stocks or mutual funds offered by companies working to have a positive impact on the world and society around them. ESG factors take into account a company's impact on:
Area:This can include a company's energy efficiency, carbon emissions, waste management and more.
Community:This factor may focus on the company's relationship with its community and the community around them. Socially responsible companies can invest heavily in community projects or in protecting their customers' data and privacy.
To steer:This factor takes into account how a company is managed, such as the corporate structure, executive compensation or the diversity of board members.
ESG factors are not universal across the board, but common criteria include:
How is the ESG score calculated?
An ESG rating or ESG score is calculated by third-party rating agencies using their own scoring methods. Analysts at these companies review company information, conduct interviews with management and review publicly available annual reports or sustainability reports to determine a company's ESG score.
Popular appraisal firms include, but are not limited to:
- MSCI:Publishes ESG ratings of 8,500 companies worldwide
- ISS-ESG:Publishes ratings of 11,800 issuers and 25,000 funds
- Sustainability analysis:Publishes ESG ratings of more than 13,000 companies
- Refinitive:Calculates ESG scores of 11,800 companies
- FTSE Russell:Publishes ratings for 7,200 securities
“Each vendor has its own algorithm for calculating these scores, which typically focuses on materiality (the impact a KPI will have on the bottom line), with adjustments for industry, size and missing data,” says Townsend.
It is important to note that not all investors base their decisions solely on these assessments. Some investors will use their own methods to assess a company's ESG score or may even engage a financial advisor to conduct their own analysis.
Advantages and disadvantages of ESG investing
Like any investment strategy, ESG investing comes with its own risks and rewards. Some of the main pros and cons are:
Benefit: ESG investing helps investors align their investment strategy with their values.While the ultimate goal for many investors may be to build long-term wealth, many investors do not want to do this at the expense of the environment or their community. ESG investing is a way for them to assess which investments will not only give them a strong return on their investment, but also help them do some good in the process.
Con: “Greenwashing” can make it difficult to know which companies are actually sustainable.Many companies are guilty of using dishonest marketing tactics to convince consumers and potential investors that they are making a positive impact. It is up to the investor to do their homework, consult public records and determine for themselves whether the company is sustainable. This can be difficult because ratings vary so widely among reporting companies.A studyof MIT found that six leading rating agencies had only a 61% correlation between their ESG data.
Cons: ESG funds can have a higher-than-average expense ratio.According toMorningstars 2020 USA Research into fund costsaverage expense ratios for ESG funds were 61%, compared to 41% for traditional assets.
Benefit: Strong ESG compliance can be an indicator of a less risky investment.Companies that have made a strong commitment to diversity and equality, even at the highest corporate levels, can reduce their exposure to accidents or lawsuits that could negatively impact themselves and their investors' wallets. “ESG investing is tailored to a long-term investment horizon,” says Townsend. “ESG can better position a portfolio for the future [and] help identify risks that may not materialize for three months or years.”
How to implement ESG investing
ESG investing can be a simple strategy where you (or your financial advisor) look at your investments through an ESG-friendly lens to exclude investments that do not have a positive impact in those areas.
How to get started:
1. Decide how you want to build your portfolio:
You may choose to research and evaluate stocks or funds yourself, or you may decide to work with a financial advisorrobo-advisoris the better route. A professional can point you in the direction of specific assets that meet ESG standards and align with your overall investment objectives. Several robo-advisors such as Wealthfront and Betterment offer similar services, often at lower costs.
2. Identify the criteria that are most important to you
Determine which causes are most important to you. Maybe you want to invest in a company that is making great efforts to reduce its carbon footprint, or you want to support a company that prides itself on gender diversity. Knowing what's important to you can help you narrow down your list of investment options.
3. Settle for investments that align with your goals
Once you determine the factors that best fit your goals and values, you can open an investment account and decide how much to invest and in which specific assets. A lot ofonline broker accountsThis allows you to filter investment opportunities by sector, sustainability and financial performance for all these investments.
For investors looking to make a positive impact, ESG investing can be an additional filter when building a portfolio. “ESG is a process, not a silver bullet,” says Townsend. “Investments that are otherwise attractive can fit into any strategy that incorporates ESG features.”
