Updated: Jul 13
You've likely come across the term "ESG investing" before but may be uncertain of exactly what it means. If you're in that camp, don't feel bad. The financial industry is still trying to hone in on the correct definition.
ESG stands for Environment, Social and Governance, and is used by investors to gauge the long-term viability of an organization. Each ESG factor is comprised of sub-factors that are considered when ranking companies' environmental impact, social responsibility, and corporate governance practices. The higher the ranking in each category, the more sustainable the business is likely to be over time.
Here is a sample of common ESG factors and sub-factors from Western Asset:
Origins of ESG
Technically, ESG started back in the 1960s when investors began tailoring their stock picks away from companies that didn't align with their moral or ethical values, i.e. focusing strictly on the social factor of ESG and excluding, for example tobacco companies or weapon manufacturers from their portfolio.
Over time, ESG investing has evolved to encompass the environmental and corporate impacts of an enterprise. The United Nations is known to have officially coined the term in a 2004 report urging all corporate stakeholders to embrace the idea of sustainability as defined by ESG.
If you're like most investors, you may still be wondering exactly what ESG means relative to investing in the stock market.
I'm even a little unclear of this concept of sustainable investing.
Sure, I understand what the words environment, social and governance mean individually, and incorporating all three factors into an investment strategy sounds good on paper, but how do you measure something like "conflict"? Are all ESG factors created equal? Who is in charge of these ESG rankings and are they consistent across the board?
Finally, is ESG a good investment?
Not All ESG Investments Are Created Equal
Before we answer these questions and determine if ESG is a worthwhile investment, we need to first understand that not all ESG investments are created equal.
Some ESG strategies may place more emphasis on one or more factors and less on others. Meaning, you could have one ESG investment focused strictly on environmental factors and another concerned only with governance, yet both may be classified as ESG.
To make things more confusing, the metrics for measuring each ESG factor may be different from company to company. For example, a BlackRock ESG strategy may have a lower tolerance for waste and pollution within a company than a Vanguard strategy, leading to differences in the composition of each investment.
Here is a chart showing the performance of two seemingly identical large-cap ESG ETFs from two of the biggest fund providers in the country: BlackRock and Vanguard:
Though the returns are similar, you can see there are clear differences in the three-month, year-to-date and one-year performance figures.
Investing in ESG
Regardless of the level of confusion and complexity in this space, there's still a high demand for ESG investing.
Folks wanting exposure to ESG in their portfolios have three options to choose from: DIY, active management, or passive indexing.
Option #1 - DIY ESG Investing
Under this option, you are the one in charge of the ESG ranking, screening, and stock-picking. As such, you'll be the one assessing, for example acceptable benchmarks for executive pay, pollution and working conditions and how, say Apple ranks in these categories compared to Google.
Further, you'll have to continue to monitor each of the ESG companies selected to ensure their business model remains consistent with your ESG philosophy.
Option #2 - Actively Managed ESG Funds
If you'd rather not spend your time researching and ranking each prospective stock's ESG worthiness, you may choose to outsource this task to an actively managed mutual fund or separately managed account.
Here, the funds' managers will (for a fee) be responsible for compiling and overseeing a diversified ESG portfolio of stocks and bonds based on their own interpretation of social, environmental and governance factors.
Option #3 - Passive ESG ETFs
Those who don't find value in active management and prefer to simply own an index can invest in a variety of passive ETFs that track a basket of stocks and/or bonds pre-screened and ranked for ESG.
Although the costs are generally lower than going with a mutual fund, ESG ETFs do charge more than traditional index ETFs that track more common indices like the S&P 500 given the somewhat esoteric nature of the ESG index.
Benefits of ESG Investing
As with any investment strategy, there are pros and cons investors should consider before simply hopping on board the latest investment trend.
Some of the benefits to ESG investing are:
1.Your Personal Values Aligned with Investment Strategy
There are now over 550 ESG mutual funds and ETFs to choose from, making it easier than ever for investors to allocate money toward companies whose values align closely with theirs.
In doing so, the process of building and maintaining wealth can be more rewarding for some who not only profit from their investments, but also do some good along the way.
2. Potential for Diversification
Depending on the type of strategy you use, ESG investing may offer an added layer of diversification to your portfolio. So instead of bearing the full risk of owning the stock market, an ESG strategy provides a factor-based approach that can place more or less emphasis (and money) on certain companies based on their ESG ranking, thereby creating a return pattern that doesn't correlate directly with the market.
3. Possible Outperformance
As with any investment strategy whose philosophy diverges from the traditional indexing approach, investing in ESG may deliver optimal returns in certain market cycles. However, this outperformance may not be sustainable (no pun intended) and is most certainly not guaranteed.
Drawbacks of ESG Investing
Some potential downsides to ESG investing include:
According to a recent Wall Street Journal article, ESG funds can cost as much as three times more than a standard index fund. Cost isn't everything, but definitely something to be considered when investing in ESG, especially if the ESG fund in question looks similar to an index like the S&P 500.
2. Fund Complexity
I alluded to this earlier and the fact is, every fund provider has their own interpretation of ESG. They have evaluation and screening standards specific to their ESG philosophy, which might make it challenging for investors to comprehend how their investments are being chosen, what factors are being considered, how are those factors are being weighted, etc.
3. Possible Underperformance
Performance is as much an advantage as it is a disadvantage.
ESG is still a relatively new concept and the jury is still out on whether or not sustainable investing can outperform over the long-term.
Here is a chart showing the total return of the S&P 500 compared to the largest ESG ETF, the iShares ESG Aware MSCI fund, since the fund's inception (2017).
As you can see, the ESG fund did outperform during 2021 and partially in 2022, though overall lagged the S&P by a small margin.
The sad truth is that some businesses will exaggerate or misrepresent their environmental, social or governance impact to garner more investor attention. As such, it may be challenging for you to find truly sustainable companies to invest in.
Is It Worth It?
Let's do a quick recap and ensure we answer the questions I posed from the beginning:
Question 1: How do you measure something like "conflict"?
I didn't quite touch on this in detail but if you want to understand how a fund provider analyzes each ESG factor, look at the fund's fact sheet, sustainability characteristics and sustainability screening definitions.
Question #2: Are all ESG factors created equal?
No, and this is one of the disadvantages of investing in ESG. See #2. Fund Complexity above.
Question #3: Who is in charge of these ESG rankings and are they consistent across the board?
The simple answer is you or the fund provider(s), depending on the ESG investing strategy you choose. And no, they are NOT consistent!
Question #4: Is ESG worth investing in?
Here's my take:
If you're someone looking for a new, trendy investment strategy to outperform the market, I don't think ESG is right for you.
On the other hand, if you understand the potential drawbacks of investing in ESG and are willing to accept them in exchange for the serenity of syncing your money with your values, then ESG may be something to consider.