The short version
- Socially responsible investing has grown in popularity among investors. ESG measures the environmental, social and governance impact of a company.
- While these measures can help traders ethically invest their money, there is no standard agreement on what it means for a company to be ESG.
- To avoid investing in companies that “green wash” it's important to look at things like third-party scores, doing your own research, or investing directly in ESG funds.
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What is ESG investing?
ESG investing is a type of socially responsible investing. ESG — which stands for environmental, social and governance — investing is a way to make money in the stock market by giving your money to companies whose values align with yours, as well as withholding your money from companies with opposing values.
This type of investing has become increasingly popular in recent years. In fact, money invested in ESG funds more than doubled from 2019 to 2020. The head of iShares Americas estimates that money in ESG funds will exceed $1 trillion by 2030.
How to invest in ESG companies
There are generally two ways to invest in ESG companies. First, you can invest directly in companies that meet ESG criteria. Alternatively, you can invest in exchange-traded funds (ETFs) and mutual funds.
As ESG investing and other forms of impact investing have become more popular, more funds have been created to meet that demand. Not only do these funds enable you to invest in a way that aligns with your values, but it also allows you to easily diversify your portfolio, which is more difficult to do if you invest in individual stocks.
ESG is similar to other forms of investing, such as socially responsible investing, sustainable investing and impact investing. The key differentiator is that while the others can have a broad meaning, ESG investing has three set criteria by which it judges companies, making it easier to determine which do and don’t meet the requirements.
Overall, there are plenty of potential benefits to ESG investing. The obvious perk is that you can support causes that are important to you while withholding your money from causes and activities you disagree with. At the same time, you can also increase your portfolio returns and decrease your downside risk, which we’ll cover more later.
Find out more: How to get started with ESG investing
How does a company or fund meet ESG criteria?
There are three different components to ESG investing: environmental, social and governance. For a company to truly be considered an ESG investment, it must meet at least some of the criteria in each of these three categories:
The environmental component of ESG investing looks at how a company impacts the environment. Do they take steps to reduce or offset their carbon footprint? Companies can meet environmental ESG criteria either by limiting their negative impact on the environment or by having a positive impact on the environment.
As more people begin to understand the importance of environmentalism, it becomes increasingly easy to find companies focused on their environmental impact. Many companies publicly donate a percentage of their profits to environmental issues. Others have pledged to reduce their carbon emissions, use of plastic and more.
But just as a company can meet ESG criteria by supporting environmental initiatives, a company can make itself ineligible to meet the criteria with a poor environmental impact. You’ve probably seen companies making headlines due to their environmental impact, whether through their high carbon emissions or their high level of plastic pollution.
Some additional examples of environmental criteria for ESG investing include:
- Carbon emissions
- Air and water pollution
- Energy efficiency
- Water scarcity
- Animal rights
The social component of ESG criteria looks at how a company impacts people and society. To meet social criteria, a company should aim to have a positive impact on all people, whether it be its customers, its employees or its community.
While it’s not always easy to tell what sort of impact a company has on the community, many companies have stood out for their positive — or negative — impact on people.
The pandemic has served as a unique opportunity for companies to show just how much they care about their employees. And while many companies have put their employees’ health above profit, others have made headlines for doing just the opposite. Similarly, many companies over the past two years have spoken out and taken action on issues such as racial justice and worker rights.
Meanwhile, other companies were created with social impact in mind. It’s not hard to find socially impactful companies that donate their product, or a percentage of profits, to social and community issues.
Other social criteria include:
- Diversity and inclusion
- Employee health and safety
- Customer satisfaction
- Community engagement
- Community service
- Fair labor practices
- Human rights
The final component of ESG criteria is governance, which looks at how a company is run. Companies that meet governance criteria have a transparent business model and a history of being honest with their customers, stakeholders and shareholders.
A major way that companies can succeed or fail in this category is how they treat their shareholders. Companies with good governance policies prioritize shareholder rights, ensuring they every owner has a say in the company. On the other hand, companies with poor governance policies may hide things from shareholders or make decisions the shareholders largely disagree with.
Another major area where a company’s governance policies are important is ethical and legal activity. Companies that have a history of corruption or spend much of their money lobbying for harmful policies aren’t likely to meet the ESG governance criteria.
Other examples of governance criteria include:
- Board diversity
- Executive compensation
- Political contributions
- Lobbying efforts
- Corruption and illegal activity
- Large-scale lawsuits
- Shareholder rights
How can investors tell if a company cares about ESG?
It can be difficult to know how a company stacks up to ESG criteria, especially since there’s no universal rating system. However, companies have responded to the increased demand for ESG investments by creating tools that make it easier for investors to find ESG companies. Here are two strategies for finding companies and funds that prioritize sustainability.
1. Look at ESG scores
If you’re interested in socially responsible investing, then you may want a more concrete way to know which companies meet ESG criteria and which don’t. One way you can do that is by reading up on companies’ ESG scores.
While it’s true that there’s no universally used system for rating ESG companies, there are still many tools that rate and score companies based on their adherence to ESG criteria. Companies that offer these services include S&P Global, Sustainalytics, MSCI and Refinitiv. Stock research companies like Morningstar also offer ESG ratings.
If you’re concerned about how each company’s rating system will stand up to your own standards, you can read more about their methodology on their respective websites. Another strategy could be to check a company’s ESG score across all rating companies to get a more well-rounded score.
Keep in mind that none of these ESG ratings systems are perfect. For example, the investing community was shocked by S&P Global's May 2022 announcement that it had removed Tesla (the world's largest electric vehicle producer) from its S&P 500 ESG list while moving ExxonMobil up into its top-10 holdings as part of its annual rebalancing.
2. Invest in ESG funds
Another way investors can ensure they’re investing in companies that fit ESG criteria is to invest in ESG funds. ESG funds are ETFs and mutual funds that invest specifically in ESG companies.
There are a wide variety of ESG funds on the market, and it seems the list grows longer every day. Some ESG funds focus on a specific one of the ESG components: either environmental, social or governance issues. Other funds are more comprehensive EGS funds, investing in companies that meet all criteria.
ESG funds are generally broken into two categories: inclusionary and exclusionary. Inclusionary funds invest in companies that proactively work to make a positive difference. These companies generally have higher ESG ratings than their industry peers. Exclusionary funds, on the other hand, simply avoid investing in companies that engage in harmful activities.
ESG funds often avoid investing in what is known as sin stocks, which are stocks associated with activities deemed to be immoral or unethical. Examples of sin stocks include tobacco, alcohol, firearms and gambling.
Another simple way to skip the individual companies and invest in ESG funds instead is through a robo advisor. Popular robo advisors like Betterment now have socially-responsible investing options, making it easier for impact investors to diversify their portfolios and take a hands-off approach to investing.
Find out more: Best robo advisors for ESG
How do you measure ESG performance?
One of the biggest questions people have when it comes to ESG investing is whether their returns will suffer. After all, while it’s great to support environmental and social causes that are important to you, you don’t necessarily want your returns to suffer as a result. The good news is that data consistently shows there are financial benefits to ESG investing.
First, Morgan Stanley Institute for Sustainable Investing publishes an annual report on sustainable investing. In its latest 2020 update, the institute found that sustainable equity funds outperformed traditional funds by about 3.9%. Sustainable equity bond funds outperformed by about 2.3%.
Not only are these results positive, but they’re actually improving over time. The amount by which sustainable funds outperformed traditional ones increased substantially from 2019 to 2020. This data isn’t surprising, given the statistics we shared earlier about the drastic increase in ESG investing in 2020.
The Morgan Stanley report noted that not only did sustainable investing funds outperform traditional ones, but they also had less downside risk. This was especially true during periods of increased volatility.
What exactly does this mean? It means that while it’s natural for stocks to be down across the board during market downturns, sustainable funds decreased less than their traditional counterparts.
ESG funds can provide greater risk protection
Another recent study from the NYU Stern Center for Sustainable Business reported similar findings. It found that there was generally a positive correlation between ESG and financial performance and that the improved financial performance was more noticeable over a longer time horizon.
The NYU Stern study found similar results as Morgan Stanley, indicating that ESGS funds provided greater downside risk protection. It also found that the increased financial performance of ESG investments was partially a result of improved risk management and better innovation at those companies. It wasn’t the ESG status on its own that fueled the companies’ financial performance, but that they also invested and performed well in other areas.
The one significant financial downside to ESG investing is the increased fees. A Morningstar 2020 U.S. Fund Fee Study found that ESG funds generally have higher fees than traditional funds. However, the study also found that ESG fund fees have been falling more steadily than other funds. This is good news for the future of ESG investing.
5 things to keep in mind when investing in ESG companies
There are plenty of benefits to adding ESG criteria to your investing strategy. Not only can you put your money toward companies whose values align with your own, but you also have the potential for higher investment returns.
That said, it’s always important to understand what you’re investing in. Choosing to invest in an ESG company or fund should involve just as much due diligence as investing in anything else, and it doesn’t make sense to invest in anything solely based on its ESG status. Here are a few rules of thumb to keep in mind before investing in ESG companies and funds:
1. Do your own ESG research
If a company says it’s a sustainable investment or meets ESG criteria, you may not want to take its word for it. Instead, use one of the many ESG screeners and rating companies available online to determine whether the company really meets ESG criteria.
Additionally, know that your ESG priorities may be different from other investors. Just because something says it’s an ESG fund doesn’t necessarily mean it’s right for you. Some ESG funds focus on specific criteria — environmental, social and governance.
One way to find the right funds for your portfolio is to reverse engineer your search. Identify what values and causes are most important to you and look for funds that fit. The Invest Your Values tool is one way to find funds that share similar values to you.
2. Consider investment returns
Yes, the research shows that ESG funds generally outperform traditional funds, especially over the past few years. But that doesn’t mean that every ESG company and fund outperforms the market. As you’re looking for funds to invest in, take a look at their performance for the past few years. If they underperform the market, it’s worth asking yourself why.
3. Consider the risk level
Anytime you’re investing, it’s important to do so in a way that aligns with your risk tolerance. Some companies and funds may align with your values but have a highly volatile stock performance. Depending on your age, comfort with risk and what else is in your portfolio, those higher-risk investments might not be right for you.
4. Diversify your portfolio
ESG investing doesn’t have to mean investing in individual companies based on their ESG rating. If you do that, you could end up with a portfolio made up of just a few companies. If one of those companies performs poorly, then your entire portfolio takes a hit.
It’s important to diversify your investment portfolio, and choosing ESG funds over individual companies is a great start. But remember that even one ESG fund doesn’t make a diversified portfolio. Experts generally recommend diversifying across asset types, sectors, market caps, and domestic vs. international assets.
Read more: How to diversify your investment portfolio
5. Revisit and rebalance
As with any investment portfolio, you shouldn't take a set-it-and-forget-it approach to your ESG portfolio. It’s important to check in on your investments every so often. While you probably don’t want to check their performance daily, weekly or monthly may be appropriate. Your ESG portfolio may also require rebalancing to get it back to your original asset allocation.
The bottom line
ESG investing has become increasingly popular in recent years as more investors want their portfolios to align with their values. Unfortunately, it can be difficult to know which companies and funds actually meet ESG criteria versus those who simply claim to.
The good news is there are plenty of tools available to help you filter your options. And, in what's perhaps the best news, recent data shows that ESG-focused portfolios can be just as successful (or even more so) than those that don't take environmental, social, or governance factors into consideration.
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