ESG Investing: What It Is & Investing Options
ESG investing is a strategy where the investor considers the environmental, social and governance factors of a company prior to investing.
Environmental, Social, and Governance (ESG)
ESG investing involves investing in companies that score highly on certain environmental, social, and governance (ESG) criteria. Environmental factors consider a company's impact on the natural world; social factors consider the treatment of people both inside and outside the company; and governance factors consider how a company is run.
ESG criteria are:
- Environmental: Measures what kind of impact a company has on the environment. Criteria include air and water pollution, carbon emissions, green energy initiatives, deforestation, water usage, and waste management.
- Social: Measures a company's social impact both inside the company and within the broader community. Criteria include company sexual harassment policies, employee gender and diversity, customer satisfaction, data security, local and global human rights, and fair labor practices.
- Governance: Measures how policies and actions of a company's management and board of directors drive positive change. Criteria include political contributions, executive pay, diversity of board members, transparency and disclosure, and internal corruption.
ESG Scores, Metrics, and Ratings
ESG scores are calculated by many different companies that may use varying ratings and research methodologies. While the specific criteria being measured varies by company, they typically review similar items, such as annual reports, board structure and compensation, management structure, and sustainability measures.
Some of the companies that measure ESG scores include Morningstar, MSCI, Bloomberg, and S&P Dow Jones Indices. ESG scores can vary by company and may be based upon a 100-point scale, where a higher score is better, and a grade ranging from CCC on the low side and AAA on the high side.
ESG Scoring Example
For an example of ESG scoring, the MSCI ESG Ratings Methodology considers more than 100 datasets coming from a wide range of local and global media sources. Environmental criteria include:
- Broad themes: climate change and environmental
- Social criteria: themes of human capital and social opportunities
- Governance criteria: corporate behavior and corporate governance themes
Specific factors are then measured within each theme.
How Investors Use ESG Scores
Investors who prioritize ESG factors in their investing may use ESG scores to evaluate which investments to include in their portfolio. Some ESG investors may feel that companies scoring well on these ratings may better anticipate future risks and opportunities. An ESG investor may further anticipate that a higher ESG-scoring company has potential to be a greater, longer-term strategic investment than a lower-scoring company.
Important: Some ESG rating firms communicate scores as "ESG risks," meaning that a low score imposes an environmental, social, or governance risk that these investors may want to avoid. A higher score would indicate a lower risk, and thus a more favorable rating, to an ESG investor.
Brief History of ESG
An early form of socially responsible investing dates back to the 1800s (esl.org), when the Methodist church urged its members to avoid investment in controversial industries, such as tobacco, weapons, and gambling. Modern ESG investing history began with the 1971 launch of the first sustainable investing fund, known today as Pax Sustainable Allocation Fund (PAXWX).
More recently, ESG investing has gained dramatically in popularity. According to Morningstar, U.S. sustainable funds attracted record flows in 2020 and 2021 from investors in mutual funds and exchange-traded funds.
ESG Investing Options
Investors may choose to do their own research to find ESG investing options for themselves, but they may also select among mutual funds and ETFs that focus on ESG companies. While many investors search for ESG stocks or stock funds, they may also invest in ESG bonds and bond funds.
Important: All funds and ETFs listed below are examples and not intended to be recommendations to invest.
ESG stocks are equity securities that have favorable ESG ratings. Since there are potentially thousands of stocks that can have favorable ESG ratings, investors may find it best to do their own research. Some companies voluntarily report their own ESG data in sustainability reports.
ESG Mutual Funds
ESG mutual funds are generally mutual funds that hold securities with favorable ESG ratings. Some mutual funds include ESG standards as a primary criterion of security selection, meaning that the fund manager focuses on stocks or bonds that meet the required criteria. Investors may also use a research tool, such as Morningstar's ESG screener, to find funds.
Examples of ESG mutual funds with high sustainability ratings are:
- 1919 Socially Responsible Fund (SSIAX)
- Calvert Equity Fund (CSIEX)
- Clearbridge Sustainability Leaders (LCISX)
- Fidelity US Sustainability Index Fund (FITLX)
- Parnassus Endeavor Investor (PARWX)
ESG ETFs are exchange-traded funds that typically track the performance of an index of companies that have certain positive environmental, social, and governance characteristics. There are dozens of these ETFs available on the market today.
Some of the largest ESG ETFs, as measured by assets under management, are:
- iShares ESG Aware MSCI ETF (ESGU)
- iShares Global Clean Energy ETF (ICLN)
- Vanguard ESG U.S. Stock ETF (ESGV)
- WisdomTree Emerging Markets ex-State-Owned Enterprises Fund (XSOE)
- iShares ESG MSCI USA Leaders (SUSL)
Important: Since ESG investing is often values-based and thus involves more than performance history, choosing the "best ESG investment" is a personal decision. Furthermore, investors may include other selection criteria, such as expenses or assets under management, in addition to ESG ratings, prior to selecting an investment security.
Pros & Cons of ESG Investing
Investors should know that while ESG investing may provide investors with non-financial benefits, such as social responsibility and sustainability, ESG investing also has some potential drawbacks.
Pros of ESG Investing
- Alignment with personal values: Many ESG investors seek to invest in a way that aligns with their values, such as minimizing environmental impact, or to be socially conscious. In this regard, and for these investors, ESG investing is based upon more than performance; it's about environmental and social responsibility.
- Performance potential: As with other types of investments, there are ESG stocks and funds that have historically outperformed the broad market indices, such as the S&P 500 index. Thus, investors may not have to sacrifice investment returns for their values with ESG investing.
- Variety of choice: Investors have multiple ESG investing choices that include stocks, bonds, mutual funds, and ETFs that cover almost every area of the market. This variety provides the potential for an investor to build a complete, diversified portfolio of these investments.
Cons of ESG Investing
- Missed opportunities: While there are many available ESG investments available on the market, there's no assurance that they'll be the best performers. Focusing only on ESG investments can exclude otherwise profitable investing opportunities.
- Inconsistent ratings: There are no standardized rules or guidelines on how ESG ratings are calculated. A lack of consistency among these ratings providers increases potential for the lack of objectivity and credibility.
ESG Investing Alternatives
ESG investing has been compared to and associated with similar types of investing, such as socially responsible investing (SRI), impact investing, and conscious capitalism. While there are similarities, and they may all be considered types of ethical investing, these investing styles are not all the same.
Socially Responsible Investing
Socially responsible investing, or SRI, is a style of investing that prioritizes the social impact of investing, while considering performance attributes a secondary factor. Socially responsible investments may include companies that make a positive and sustainable impact. SRI themes may include religious, political, or personal values.
The primary difference between SRI and ESG is that SRI may have more stringent selection criteria. For example, an SRI fund may select or eliminate an investment security according to specific social or ethical guidelines.
Impact investing involves the creation of investment portfolios for the purpose of using money to make positive and measurable social and environmental impact. In addition to providing capital to address certain social and environmental concerns, impact investing provides a return to investors.
Where impact investing differs from ESG investing is that impact investing focuses more on producing positive outcomes; whereas ESG investing does not necessarily focus on impact.
Conscious capitalism is an economic philosophy the focuses on what money can do for people and the environment. Thus, conscious capitalism is more of a way of thinking than an investment style. The idea of conscious capital was developed and introduced by Whole Foods, Inc co-founder, John Mackey, and marketing professor, Raj Sisodia.
Where conscious capitalism differs from ESG is that conscious capitalism is more of a philosophy that inspires a way of thinking about money and investment, whereas ESG is an investment style.
ESG investing offers a means of investing in a style or strategy that aligns with the values of an individual investor or a company. The recent surge in the popularity of investing in a socially and environmentally conscious way has created more ESG investment options to choose from. As with other investment types, investors should do their own research to see if ESG investing is a good idea for their own personal or financial goals.
This article was written by
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