Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.
Whether it’s the shoes we wear, the cereal we eat or the washing-up liquid we use, by choosing brands that align with our values, we’re able to vote with our wallets for the kinds of businesses we want to support. It can be the same with our investment strategies.
So, how can you get into ESG investing? What are the advantages and disadvantages? Can you really make a decent return when you’re driven by principles? Let’s dig into the details to answer these questions…
ESG investing in a nutshell
ESG investing involves selecting investments based not only on potential performance but also on how a company is run and how it treats its employees and the environment.
Because our values, drivers and motivators are all different, for some people this could mean avoiding companies producing alcohol or tobacco. For others it could mean shunning businesses involved with fossil fuels, gambling and human rights violations. Or it could mean investing in companies that ‘do no harm’ – i.e. those that treat their employees well or have a low carbon footprint.
In essence, ESG investing balances portfolio returns with a social responsibility. An ESG investor favours companies making a positive impact on people, society and the environment.
The jargon busted: ESG, SRI or impact?
If you’ve explored the idea of investing according to your principles, you’ve probably seen a few phrases thrown around. In addition to ESG funds/stocks, people also talk about ‘ethical investing’, ‘sustainable investing’ or ‘socially responsible investing (SRI)’. You may also have heard the term ‘impact investing’ used in these conversations.
Whenever you see these terms, it’s likely both values and returns are being considered during the investment decision-making process.
"It's frequently noted ESG investing dates back to Methodists and Quakers in the early 1900s – these groups avoided investing in companies involved in gambling, alcohol and weaponry."
What are the different types of ESG investing?
Whatever you call it, this type of investing is based on your values and what you care about. Let’s look at some of these in more detail:
Environmental investing: is buying companies that strive not to harm the environment and/or improve it. Companies that produce products or services that cause major harm to the environment – for example oil companies – would normally be avoided as part of this strategy.
Social investing: is purchasing companies that strive not to harm people or society and/or improve it. This typically means avoiding companies that produce/provide alcohol, tobacco, gambling or weapons. It may also involve focusing on companies striving to address social inequalities – including within their own workforces.
Governance investing: focuses on companies that are run well. This may reflect the composition of their management or how they treat employees. Firms that use child labour or have a poor compliance reputation may be excluded when investing through this lens.
These three factors are often combined when assessing companies to create an overall ESG score. This can then be used to determine whether an organisation can be included in a portfolio taking these values into account.
A couple more terms to look out for:
Faith-based ethical investments: those that align with a person’s religious beliefs. It’s frequently noted ESG investing can be dated back to American Methodists and Quakers in the early 1900s – these groups avoided investing in companies involved in gambling, alcohol and weaponry.
Impact investing: these strategies generally seek to achieve a particular outcome. A standard ESG fund may, for example, simply look to avoid investing in fossil fuels. An impact fund, however, could look to actively invest in companies that focus on renewable energy production.
"One of the key drivers of growth has been the climate change discussion – especially post-Pandemic – which has encouraged people to consider better environmental choices."
How has the ESG investing sector grown?
Between 2019 and 2021, global assets in ESG investment products almost tripled, rising from roughly $1tn to $2.7tn, according to data from Morningstar. In 2021 alone, more than $596bn was invested in these funds. That compares to just over $172bn in 2019.
One of the key drivers of growth has been the climate change discussion – especially post-Pandemic – which has encouraged people to consider better environmental choices.
A survey conducted in 2020 by Boston Consulting Group had 70% of participants saying they’d become more aware of the link between human activity and climate change following the onset of the Covid-19 pandemic. Three-quarters of respondents said environmental issues were as concerning as – or even more concerning than – health issues.
"Each ETF has a prospectus outlining what it invests in, what it doesn’t invest in and how it makes that decision."
So, how do you invest sustainably?
If you’re looking to get into ESG investing and willing to let someone else decide if a company is sustainable or not, then ETFs (exchange-traded funds) could be a good choice.
Each ETF has a prospectus outlining what it invests in, what it doesn’t invest in and how it makes that decision. Most ESG-focused ETFs also have general criteria, such as avoiding oil companies or only investing in firms with high ESG scores. While these criteria can be vague, such funds provide an investment vehicle that is at least somewhat screened to only hold sustainable investments.
Another option is to seek out stocks based on how the company is run. This is research-intensive, as companies often have many operations and work in multiple countries. If you do want to go down this path, here are some things to look at:
The company’s mission and policy statements. Precise, data-backed facts may be better than vague claims.
Look for certifications. If they say they are green, are any reliable third parties saying they are as well? Useful tools to check for include the online MSCI ESG Ratings search tool and S&P Global public ESG evaluation reports.
Search the company name and ‘ethical’ or ‘unethical’ to see the company’s online presence.
There are some third-party companies that provide ESG rankings of firms. These consider many elements and then provide a score reflecting how ethical or sustainable a company may be. Seeing which companies rank higher based on your selected values could save you some research time or provide a list to further research.
Email or phone the company and ask what they invest in, how they make their products, and so on.
Check the company’s annual statements. An increasing number of firms are facing pressure from shareholders to be more sustainable and will likely point to any actions they are taking in their public reports.
Additionally, you may want to seek out a professional who can assist you in finding ethical investments, such as a financial advisor who is a signatory of the United Nation’s Principles for Responsible Investment. These professionals should be more familiar with sustainable investing options.
The grey areas
One of the biggest criticisms of ESG investing is that criteria for what is and isn’t sustainable can be vague.
You may, for example, believe a producer of vegan hamburgers is an ethical stock to buy. But what if those burgers have a high fat and salt content? Someone else might take a different view and pass on the stock as a result. A company producing electric vehicles may appear environmentally responsible, but if its manufacturing process produces lots of toxic chemicals and emissions, investors must weigh up the pros and cons before parting with their cash.
It’s also worth noting each ESG fund has different parameters, and these may not necessarily align to your values.
Another misconception to clear up is that ESG portfolios only focus on companies involved in activities like renewable energy, recycling and sustainable agriculture. Many funds will have substantial allocations to popular blue-chip stocks – so long as these have met predetermined sustainability criteria.
"If more people start to invest in sustainable companies, other businesses may start to take note."
What are the advantages?
ESG investing has several advantages, both personal and societal:
There’s the emotional satisfaction you get from investing in companies that marry with your ethics and values. If the investment does well, there is also financial satisfaction.
If more people start to invest in sustainable companies, other businesses may start to take note. Look at how oil and gas companies like BP and Royal Dutch Shell have started to produce more renewable energy assets in recent years as investors have shown more interest in green power.
Investing sustainably creates awareness about voting with your wallet. Some investors in ethical companies may also start to buy their products to keep revenues flowing while also avoiding products from companies they consider unethical.
What are the disadvantages?
ESG investing also has some drawbacks compared to conventional investing, which is less concerned with how a company acts and is more concerned with performance.
Ethical investing requires research to make sure companies or funds align with your values.
Companies change over time and may stop or start doing something you do – or do not – like. To find an investment that matches your ethics, you must look at both what the company is doing now and how it plans to grow, while still maintaining its ethical standards.
ESG ETFs or funds typically have higher fees than their traditional counterparts for the reason mentioned above – ESG investing requires research into each company’s operations.
Ethical investing eliminates many companies as potential investments. This could negatively impact returns and portfolio diversification.
Investing in ethical companies doesn’t mean the unethical ones cease to exist.
So, does ESG investing work?
The nature of ESG investing means its success is not as simple as just measuring returns.
Investing sustainably may give you the satisfaction that you’re backing companies with positive ESG factors, such as not polluting, high labour standards, respecting human rights, and anti-bribery/corruption.
As for returns, between 2018 and 2021, many ESG funds/ETFs have performed similarly to major index ETFs in their respective country. And, over some periods, have even outperformed the major indexes like the FTSE 100 and S&P 500.
This indicates that ESG investors are not giving up much in terms of returns. It also shows that research doesn’t need to be intense if you’re willing to put matters in the hands of an ETF provider. Just be sure to check your values are aligned with that of the investment product.
Capital at risk.