An Introduction to ESG Investing

ESG is all about putting your money where your values are – literally. This practice takes investors a step beyond merely shopping local or avoiding big box stores. When you invest according to ESG guidelines, you’re putting your capital to work with companies that shares your values and beliefs in the way they work.

What is ESG Investing?

ESG stands for “Environmental, Social, and Governance,” and is synonymous with sustainable investing, impacting investing, and socially responsible investing.

This practice is growing amongst younger crowds especially, although older investors are beginning to see the potential merits. In fact, many companies now offer financial products that follow ESG criteria, while others are working to better their scores to appeal to a broader range of investors.

ESG scores are assigned by various analytical institutes based on similar sets of criteria. While some institutions will grade the same company in slightly different ways, they all follow similar guidance for environmental, social, and governance factors.

Let’s discuss the different aspects of ESG scores in more depth.

Environmental Factors

A company’s environmental score takes into account the extent to which they are a steward of nature. Several factors make up a company’s environmental impact, such as their:

  • Energy use
  • Waste and pollution production
  • Natural resource use and conservation
  • Treatment of animals

This aspect of ESG is used to examine both how their practices impact nature, as well as how they may help nature, by evaluating their potential risks.

For instance, their environmental score may look at whether they own contaminated land, produce hazardous waste, or put out toxic emissions. At the same time, their score will be impacted by how they handle these issues, as well as whether their management practices are in line with – or better than – government regulations.

Social Factors

A company’s social score examines both internal and external factors. In essence, this is how they manage their business relationships with employees, vendors, and customers, as well as the community as a whole.

For example, a company with a poor social score may frequently partner with companies that hold dissimilar or contradictory values that negatively impact their workers. They may also have a poor track record in diversity and equal opportunity hiring practices, or a history of human rights violations in developing countries.

On the other hand, a company with a higher social score will keep their working conditions in line with government regulations. They may also allot a percentage of its profits toward community development projects or donate paid or volunteer hours to further community development efforts.

Governance Factors

A company’s governance score looks at how a company is governed and who is in charge. This aspect of ESG examines leadership, audits, and internal controls to determine whether or not a company is well-governed.

Factors that affect governance include:

  • Executive pay against worker pay
  • Diversity in leadership
  • Responsiveness to shareholder demands

In essence, a company’s high governance score is reassurance to investors that their capital is going into an organization that avoids conflicts of interests, plays fair with political contributions, and doesn’t engage in illicit practices.

Selecting Among Factors

Investors often consider several ESG factors when researching their investments. These may include both general and industry-specific issues, such as climate change, human labor violations, and data privacy and security.

This allows investors to make independent determinations across industries, such as between finance and manufacturing, or healthcare and agriculture.

However, no company can be perfect in every category. Thus, investors have to decide what’s important to them, and to what degree.

Can they forgive sustainability concerns if the company makes large donations to poor communities? What about companies that take advantage of cheap labor in developing countries that invest their profits in fighting fires in the Amazon rainforest?

The Evolution of ESG Investing

ESG investing gained prominence during the social movements in the 1960s, 70s, and 80s. At that time, it was known as SRI – socially responsible investing.

SRI investors, both institutional and retail, began to exclude stocks and industries based on activities including involvement in the South African apartheid regime and tobacco production. The practice grew and spread to include other exclusionary bases, including environmental violations and corporate misconduct.

Over time, SRI and ESG investing grew more distinct. While both are designed to cultivate responsible portfolios, there are a few key differences.

SRI investors often use an exclusionary approach to screen investments. They may filter out entire industries, such as “sin stocks” like alcohol and tobacco companies, as well as industries engaged in weapons production or wartime activities.

However, ESG investing may exclude much of an industry while still including companies that have positive impacts in society or on the environment.

Furthermore, SRI investors tend to focus on companies that are “morally good” according to personal ethical guidelines. Underlying motivations may include religious beliefs, political values, or personal concerns with an investment or industry.

On the other hand, ESG investors rely on ESG analysis to shape an overall valuation of the company.

Why ESG Investing?

ESG investing is about aligning your portfolio with your moral compass. However, there is also evidence that ESG investments perform similarly to traditional investments – at less risk to the investor.

For example, a recent study from MSCI found that ESG investments have positive impact valuations and performance. In fact, their findings show that companies with higher ESG ratings perform better in three specific categories: higher profitability and dividend payments, lower tail risk, and lower systematic risk exposure.

So, in other words, companies that adhere to ESG guidelines experienced less profit and earnings volatility, lower capital costs, and fewer instances of fraud, accounting violations, and natural resource violations.

Conversely, companies with lower ESG scores showed that they were more prone to high capital costs, volatility in the stock market, and at a higher risk of major ethical and regulation violations. These lead to lower profitability and dividend payments, higher betas, and more incidences of corruption, fraud, and even bribery.

Additionally, a 2019 white paper from the Morgan Stanley Institute for Sustainable Investing compared the returns from various sustainable funds to traditional investments and found that total returns were similar between 2004 and 2018.

The same study also discovered that sustainable funds experienced consistently lower risk than conventional funds, regardless of asset class.

Furthermore, during turbulent markets – such as in 2008 and 2015 – traditional funds experienced a larger downside deviation than sustainable funds. This meant that traditional funds saw a higher potential for loss than funds with higher ESG scores.

Other studies have shown that ESG may actually outperform conventional investments.

For example, JUST Capital maintains a fund that selects ESG investments from the top 50% of companies in the Russell 1000. Since their inception, JULCD has returned 16.54% annualized returns compared to 15.31% from the Russell 1000.

Risks of an ESG Approach

The largest drawback of an ESG approach is the extent to which it can impact diversity in your portfolio.

For instance, some ESG funds operate similarly to SRI investing in that they exclude entire industries. Typically, these are left out due to environmental regulations – such as oil and tobacco companies.

Furthermore, many companies that adhere to ESG guidelines are large-cap, which limits your exposure to small- and midcap stocks.

This impact on your diversity has the potential to limit your returns.

For instance, if you invest only in solar energy, and a massive swath of wildfires block out the sun for months on end, your portfolio may take a hit.

Not to mention, by excluding some industries entirely, you miss out on gains in those industries.

However, ESG investors can mitigate some of these risks by including companies and industries that have proven track records of making improvements in ESG standards.

After all, no company will be perfect – but many are upping their standards.

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