ESG investing has experienced substantial growth in recent years. In 2020, the US SIF Foundation estimated a total of $17.1 trillion in ESG assets under management, a 42% increase from two years prior. Clearly, there’s a growing trend here; but what exactly is ESG investing? Find out how it works, how it plays a part in investment management, plus the potential benefits and drawbacks of incorporating an ESG strategy into your investment portfolio.
An official ESG investing definition involves using a set of criteria based on a company’s environmental, social, and/or governance practices to decide whether or not to include that company in your portfolio.
However, there’s no one-size-fits all list of ESG products or companies. After all, it’s a form of values-based investing, and as an individual investor, your values will look different than someone else’s. In general, here’s a brief overview of the three components of ESG investing.
You may have heard of sustainable investing or environmentally responsible investing. The environmental component of ESG investing refers to how a company approaches its environmental impact. At a very broad level, making choices in this category could exclude or limit certain types of energy companies that you may disagree with, or include those that are increasing their focus on things like renewable and sustainable energy sources.
This ESG issue could also look at how any company handles its environmental impact, from the size of its carbon footprint to its manufacturing process.
The “S” in ESG represents the investor’s preference for socially responsible investing. In other words, you would want to evaluate the social aspects of the companies which gives you the opportunity to pick investments that align with your own values. You can review the company’s internal practices on things like employee relations, workplace health and safety, and diversity issues. Additionally, you may look at a company’s own corporate social responsibility programs to see whether or not their initiatives align with your own values. These social criteria are the basis for this category of ESG score.
Corporate governance looks at how a company’s leadership and board members are managed. You may review executive compensation (particularly compared to worker pay), diversity in leadership and board positions, and shareholder rights. A history of corruption or litigation may also influence your decision of whether or not to invest in a particular company or industry.
Your approach to ESG investing can include individual stocks, exchange-traded funds (ETFs), and/or mutual funds. For instance, you may have specific companies you want to support (or avoid altogether) because of how their practices stack up against your values.
There are also ESG ETFs and mutual funds available, which are all structured differently. For instance, a fund may avoid “controversial” companies or industries, like those tied to tobacco, alcohol, gambling, or nuclear power. Other funds may strictly include companies that are proactively working towards a similar goal, like growing clean energy or promoting diversity and gender equity across workplaces, marketplaces and communities.
Finding the right ESG investments takes time and research. Just because something is labelled as an ESG mutual fund, for example, does not necessarily mean the assets included are in line with what you want to achieve with your investments.
It is helpful to work with your financial advisor to establish investing guidelines based on your values and goals.
There are a number of different ways you can support organizations that uphold your individual values. At D&Y, we help you determine what those values are and how your portfolio can help meet those needs. Here are four distinct approaches we use either separately or combined together as part of our clients’ ESG investing strategies.
An integration approach allows you to incorporate ESG factors alongside traditional investment recommendations made by your financial planning team. It is less restrictive in that you don’t have to entirely rule out companies, industries, or countries because of certain business activities. Instead, you can thoughtfully choose investments that reflect your values in some way. Oftentimes, it involves a company that is shifting towards a different business model, even if the bulk of their current business isn’t focused on an ESG standard.
How the process works: With an integration approach, your financial advisor uses ESG data alongside traditional investment analysis. There’s no exclusion involved; instead, you focus on investing in good companies with sound ESG practices that help to improve the overall well-being of financial and non-financial stakeholders. In some cases, this involves investing in growth-oriented companies that are repositioning their business for the greater good (think of an energy company navigating the transition from fossil fuels to more sustainable resources).
Another option for ESG investing is portfolio screening. Unlike ESG integration, this involves either an exclusionary or inclusionary screening process (or a mix of both). Your advisor can either exclude or underweight certain sectors, countries, or securities that don’t align with your values.
How the process works: Based on your particular interest, your advisor can either omit or underweight the companies that don’t align with your particular values. They can also overweight particular companies you believe in most. Creating a plan with your advisor that best helps you achieve your financial goals while also aligning with your values is what matters most.
Impact investing involves targeting thematic investments (usually in private markets), to generate both a positive impact as well as a financial return. The issues could be societal or environmental, like companies that are actively working on renewable energy sources or clean water projects. It’s the most direct form of ESG investing because you’re supporting companies that are working to solve the issues you care about.
How the process works: Impact investing targets specific public and private investments in areas needing the most improvement. Think about organizations helping to provide clean drinking water in rural areas of Africa, or building shelters and developing farmland to help stave off world hunger.
ESG investing from an advocacy focus uses your resources to positively influence corporate behavior on the issues that matter to you. This can include fundraising for charitable organizations or donating to impact a specific cause. Public activism and encouraging action at a local level along with directly communicating with companies or policymakers are other ways to get involved.
As with any type of investment, ESG investing comes with risk on both sides. With the help of your financial advisor, you can weigh the ups and downs of each decision. Here are a few starting points on what to expect from ESG investing, both positively and negatively.
Of course, the biggest benefit of ESG investing is the ability to invest ethically and promote companies you believe in. If there is some type of litigation based on poor governance or an environmental catastrophe due to a company’s operations, stock prices could drop dramatically.
There’s no crystal ball in being able to predict these events, so it’s impossible to predict the future of any company or stock. However, research is starting to show that focusing on ESG stocks may not actually hinder your long-term portfolio growth and that ESG portfolios may perform on par with traditional investments.
Still, there are some potential drawbacks of ESG investing to consider before jumping in. First, it is not wise to remain blind to performance. Tap into the experience of your financial advisor to strike a balance of reaching your financial goals while maintaining the level of integrity that’s most important to you.
Also be wary of missing out on potential growth because of exclusionary ESG investing. There may be companies that deserve a place in your portfolio but aren’t necessarily included in an ESG mutual fund or otherwise specifically categorized as an ESG stock — even if their business model and governance aren’t controversial.
Finally, it’s important to perform your due diligence in determining whether or not a company meets your values. Some may falsely market themselves as having a robust corporate social responsibility program, for example. But in reality there may be issues with leadership that may later lead to a scandal. In other words, you may need to track your ESG investments to make sure they are living up to your expectations.
Include your financial advisor in the discussion about how you can best incorporate ESG investing into your overall financial plan. At D&Y, we believe the best path to reaching your goals revolves around a holistic approach, and we’re happy to discuss how ESG investing can be utilized as a piece of your financial planning strategy.
There can definitely be a place for ESG investing in anyone’s portfolio. The important thing is to clearly identify the values that are most important to you.
When it comes to investing, you want to find a wealth advisor that understands your goals. Dowling & Yahnke Wealth Advisors can help you invest in companies that align with your values while still staying on target with your financial goals.