What is ESG Investing?
ESG investing is not a new idea but it has become increasingly popular in recent years, and possibly more so lately due to the social and health issues we are facing as a nation. ESG is an investment method that grew out of the philosophy of socially responsible investing (SRI). The letters “ESG” stand for environmental, social, and governance. Those who invest in ESG are interested in supporting companies that prove, through their internal and external operations, that they are committed to taking responsibility for their impact on the world around them.
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The idea of SRI can be traced back about 200 years but was revived in the 1960s as passions flared around the Vietnam War and the civil rights movement and people sought to divest themselves of investments they believed to be harmful and invest in those that made a positive impact. SRI funds were developed to either screen out companies that produced unsavory products like alcohol, tobacco, or weapons. Others used a more positive screen to seek out products that made a positive impact due to their ethical, moral, or religious nature.
The screening techniques were often criticized for screening out companies that may have a negative impact in one area but compensate for it with a much more positive impact in other areas. For example, a company like Amazon may be screened out for its impact on smaller competitors, despite the fact that they have invested in fleets of energy efficient vehicles to reduce their environmental impact.
ESG is an evolution of SRI, which takes a more layered approach to analysis, scoring companies on multiple factors within the three categories: environmental, social, and governance. If you’re interested in a more detailed look at this evolution, Forbes does a great job.
AND POTENTIAL RETURNS ARE BETTER THAN YOU MIGHT THINK.
People have become increasingly attracted to SRI because they see it as a way to make a positive impact on their communities, country, and even the world. However, some were alienated by the perception that SRI funds inherently offered a lower rate of return. That may have been true of older investment products, but data indicate that the opposite may be true today.
A study by Morgan Stanley noted that SRI mutual and exchange-traded funds offered total returns that were comparable to similar traditional investments during the time span of the study, which was from 2004 to 2008. The study gets more interesting though, when they examine turbulent market years like 2008, 2009, 2015, and 1018. During those years, when the potential downside risk was large, sustainable funds had a “significantly smaller” deviation than traditional funds.
The final ruling? The report indicates that “[t]he returns of sustainable funds are in line with those of traditional funds, while also offering lower downside risk for investors. What’s more, in an uncertain market, sustainable funds may offer a layer of stability for investors looking to reduce volatility.”
The data supports the simple logic that companies that invest in themselves and the wellbeing of the environment and society are stronger and more profitable, and are therefore better positioned to offer greater returns.
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WHAT ARE THE SCREENING CRITERIA?
Research methods to score companies for inclusion in an ESG products can vary from investment to investment and from fund to fund, but here are some of the criteria investors may use to determine if a company mirrors their values within the three categories.
- Environment: carbon footprint, environmental protection policies and goals, use of renewable energy sources, recycling practices, relationship with the Environmental Protection Agency, treatment of animals, protection of water sources, disposal of hazardous waste, and more.
- Social: treatment of employees, relationships with vendors and other organizations and the ethics of vendors and organizations they work with, community involvement and encouragement of employee volunteer and community involvement, relationship with and treatment of consumers, public stance on social justice issues, etc.
- Governance: accounting methods, executive compensation and perks, diversity of leadership (board, directors, management team), ability of stockholders to vote on important issues, accounting methods, the use of political contributions in exchange for favorable treatment, legality of practices, and more.
HOW DO I INVEST IN ESG?
As with any type of investment, there are a variety of ways to invest in ESG products. You can do your own research and invest in a company that meets your personal criteria for ESG. However, most people aren’t able to or don’t want to conduct the research, so they may opt for investments that have already been vetted by professionals in the industry.
You may want to invest in individual companies, exchange-traded funds (ETFs), mutual funds, or portfolios comprising a variety of investment products. One thing to consider is that ESG investments may carry a higher cost because of the due diligence screening necessary to create them, so people often opt for ETFs, which allow you to invest in an index of previously-vetted ESG products that can be managed passively (and therefore less expensively than actively-managed funds).
The simplest way to get started with ESG is to speak with your financial advisor, who can help you find an investment or develop a portfolio of investments that reflect your values and meet the needs of your short- and long-term investment goals.
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The views and opinions expressed in this blog are those of the authors and do not necessarily reflect those of VSECU.
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