Investors consider a number of different factors when evaluating different investment opportunities. This might include the level of risk associated with a particular asset, potential returns, or the costs and fees involved. But many investors are now adding sustainability as a requirement before putting their money into any one asset.
In recent years, ESG investing has skyrocketed in popularity—and companies are taking note. One report by MorningStar found that the number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 534 in 2021, up 36% from 2020.
“ESG investing is a process that focuses on long-term risks ignored by classic Wall Street analysis,” says Blaine Townsend, CIMA™ and executive vice president and director of the Sustainable, Responsible and Impact Investing Group at Bailard, Inc., a wealth and investment management firm in the Bay Area. “Think climate change, natural resource scarcity, or a toxic management culture that won’t allow a company to compete for the most talented workers.”
What is ESG investing?
ESG stands for “environmental, social, and governance”; it’s a type of investment strategy for those who want to put their money in sustainable stocks or mutual funds offered by companies who are working to make a positive impact on the world and the society around them. ESG factors consider a company’s impact on:
The environment: This might include a company’s energy efficiency, carbon emissions, waste management, and more.
Society: This factor might focus on the company’s relationship with its community and the society around them. Socially responsible companies may invest heavily in community projects or protecting the data and privacy of their customers.
Governance: This factor weighs how a company is governed, which may include company structure, executive compensation, or diversity of its board members.
ESG factors are not universal across the board, but common criteria include:
| Environmental | Social | Governance |
|---|---|---|
| Climate change and carbon emissions | Customer satisfaction | Board composition |
| Air and water pollution | Data protection and privacy | Audit committee structure |
| Biodiversity | Gender and diversity | Bribery and corruption |
| Deforestation | Employee engagement | Executive compensation |
| Energy efficiency | Community relations | Lobbying |
| Waste management | Human rights | Political contributions |
| Water scarcity | Labor standards | Whistleblower schemes |
| Climate change and carbon emissions | |
|---|---|
| Social | Customer satisfaction |
| Governance | Board composition |
| Air and water pollution | |
| Social | Data protection and privacy |
| Governance | Audit committee structure |
| Biodiversity | |
| Social | Gender and diversity |
| Governance | Bribery and corruption |
| Deforestation | |
| Social | Employee engagement |
| Governance | Executive compensation |
| Energy efficiency | |
| Social | Community relations |
| Governance | Lobbying |
| Waste management | |
| Social | Human rights |
| Governance | Political contributions |
| Water scarcity | |
| Social | Labor standards |
| Governance | Whistleblower schemes |
How are ESG scores calculated?
An ESG rating or ESG score is calculated by third-party rating companies that use their own proprietary scoring methods. Analysts at these companies evaluate corporate disclosures, set up interviews with management, and review publicly available annual reports or sustainability reports to determine a company’s ESG score.
Popular rating companies include, but are not limited to:
- MSCI: Publishes ESG ratings on 8,500 companies, globally
- ISS ESG: Publishes ratings on 11,800 issuers and 25,000 funds
- Sustainalytics: Publishes ESG ratings on more than 13,000 companies
- Refinitiv: Calculates ESG scores on 11,800 companies
- FTSE Russell: Publishes ratings on 7,200 securities
“Each vendor has their own algorithm for calculating these scores, which typically focuses on materiality (the impact a key performance indicator will have on the bottom line for a company), with adjustments for industry, size and missing data,” says Townsend.
It’s important to note that not every investor bases decisions solely on these ratings. Some investors will use their own methods for evaluating a company’s ESG score or may even seek out a financial advisor who can conduct their own analysis.
Pros and cons of ESG investing
Like any investment strategy, ESG investing comes with its own set of risks and rewards. A few of the major benefits and drawbacks include:
Pros
- 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 don’t want to do so at the expense of the environment or their community. ESG investing is one way for them to evaluate which investments will not only give them a strong return on their investment, but also help them do some good in the process.
- Strong ESG adherence may be an indicator of a less risky investment. Companies that have made a strong commitment to diversity and fairness even at the highest corporate levels could lessen their exposure to accidents or lawsuits that could negatively impact them and their investors pockets. “ESG investing is aligned with a long-term investment horizon,” says Townsend. “ESG can better position a portfolio for the future [and] help identify risks that might not be reflected over the next three months or year.”
Cons
- “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’re making a positive impact. The onus falls on the investor to do their homework, review public records, and determine for themselves if the company is sustainable. This can be difficult because ratings vary so widely across reporting companies. One study by MIT found that across six prominent rating companies, there was only a 61% correlation among their ESG data.
- ESG funds may carry higher-than-average expense ratios. According to Morningstar’s 2020 U.S. Fund Fee study, average expense ratios for ESG funds stood at 61% compared to 41% for traditional assets.
How to implement ESG investing
ESG investing can be a simple strategy that involves you (or your financial adviser) taking a closer look at your investments with an ESG-friendly lens to weed out investments that aren’t making a positive impact in those areas.
Here’s how you can get started:
1. Decide how you’ll build your portfolio:
You might choose to research and evaluate stocks or funds on your own, or you might decide that working with a financial adviser or robo-advisor is the better route. A professional can point you in the direction of specific assets that meet ESG standards and align with your overall investing goals. Several robo-advisors like Wealthfront and Betterment offer similar services, often at a lower cost.
2. Identify the criteria that is most important to you
Determine which causes are most important to you. Maybe you’re looking to invest in a company that is putting a ton of effort behind reducing its carbon footprint, or to support a company that prides itself on gender diversity. Knowing what matters to you can help you narrow down your list of investment options.
3. Settle on investments that align with your goals
Once you’ve determined the factors that most closely align with your goals and values, you can open a brokerage account and decide how much you want to invest and in which specific assets. Many online brokerage accounts allow you to filter investment options by sector, sustainability, and financial performance across these investments.
For investors who want to make a positive impact, ESG investing can be an additional filter when building a portfolio. “ESG is a process, not a panacea,” says Townsend. “Investments that are otherwise attractive can fit into any strategy that incorporates ESG characteristics.”
