What is ESG investing? A guide to socially responsible investing
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ESG investing has become quite popular in the last few years, but what is it? ESG stands for environmental, social and governance, and it’s a type of investing that focuses on those three factors. ESG investing may also be called social responsibility investing or social impact investing because of its emphasis on trying to do good with your investments.
Interest in ESG investing has been soaring lately:
- Worldwide ESG assets number into the trillions, according to Bloomberg Intelligence. At the start of 2021, ESG assets were valued at $35 trillion, and that figure is projected to grow to $50 trillion by 2025.
- In 2021, global mutual funds and ETFs focused on ESG grew their net asset value by 53 percent, to a total of $2.7 trillion.
- After that growth in 2021, ESG funds now comprise 10 percent of worldwide fund assets.
- About 29 percent of financial advisors said their clients had asked more about ESG strategies in the last 12 months, according to a 2021 report from Natixis Investment Managers.
Here’s what ESG investing is, how it works and the benefits and drawbacks of the approach.
Table of contents:
- What is ESG investing?
- How ESG scores are calculated
- ESG investing is on the rise
- 3 benefits of ESG investing
- 4 key concerns with ESG investing
- Get started with ESG investing
- Frequently asked questions
What is ESG investing?
Proponents of ESG investing focus on three key features of companies to guide their investment decisions. They then invest in companies that demonstrate these values and divest, or sell, companies that don’t meet these criteria. These three areas are:
- Environmental – These companies focus on environmentally friendly technologies or mitigating their impact on the environment by investing in green infrastructure. These companies may also emphasize how humanely they treat animals and use natural resources.
- Social – These companies emphasize healthy social dynamics, respecting racial, gender and sexual diversity, and take care of human stakeholders through fair pay, for example. They also work with other people and companies that respect these values.
- Governance – These companies emphasize how they are governed, including the structure of executive compensation, objective reporting to their shareholders and other stakeholders, and how they organize the board of directors fairly.
How ESG scores are calculated
Which companies are considered ESG companies? Both investors and third-party analysts evaluate companies on the three criteria and provide ESG ratings on the companies. Even individual investors can now evaluate companies with the help of open-source ESG tools.
Fund management firms, including those that create mutual funds and exchange-traded funds (ETFs), may analyze public companies on ESG criteria and construct their funds using them. Other firms use the work of third-party analysts to evaluate publicly traded companies, which need to meet certain criteria to be included in the funds.
Research firm MSCI offers one model of ESG ratings, grading firms on an AAA – CCC scale. Firms with the highest ratings (AAA, AA) comprise just 20 percent of all companies evaluated, and lead their industry “in managing the most significant ESG risks and opportunities.”
MSCI evaluates 35 ESG issues across these three key dimensions:
- Environmental, including carbon emissions, water stress, raw material sourcing, toxic emissions and waste, cleantech and renewable energy.
- Social, including labor management, health and safety, product safety and quality, consumer financial protection and community relations.
- Governance, including issues surrounding the board of directors, pay, business ethics and tax transparency.
Even individual investors can evaluate publicly traded companies with the help of analysis tools at Interactive Brokers, which offers a sophisticated third-party ratings system.
ESG is on the rise
ESG investing has grown in popularity very quickly, whether in terms of money flowing into the space, investors interested in ESG stocks or just overall familiarity with ESG:
- Money is flowing in. ESG assets are poised to rise to $41 trillion by the end of 2022, according to Bloomberg Intelligence. Estimates peg 2025 ESG assets at $50 trillion.
- ESG owns a bigger share of the pie. After growing for years, ESG funds now hold 10 percent of worldwide fund assets, says Bloomberg Intelligence.
- The pros are on board. About 75 percent of professional investors are using ESG strategies, according to a 2021 survey from Natixis Investment Managers.
- ESG looks set to become standard. About 59 percent of financial advisors expect ESG investing to be standard industry practice in five years, says Natixis.
- ESG aligns with investor values. About 77 percent of investors surveyed by Natixis say it’s important that their investments and beliefs align.
- Younger investors like it. About 95 percent of millennials and 97 percent of Gen Z familiar with ESG investing said a company’s ESG factors played a role in investing, according to a Yahoo Finance-Harris Poll.
Across what seems like every dimension, ESG investing is growing in popularity and money with investors, advisors and other financial pros.
3 benefits of ESG investing
ESG can offer some potential benefits to investors who are looking to use it to screen for investment opportunities.
1. Returns are generally strong
Some research suggests that investing in socially responsible companies may actually help your returns, not hurt them. But other research suggests the opposite: that investors must give up at least some level of returns to invest in ESG-friendly companies. Either way, the research suggests that ESG returns can still be attractive.
For example, the iShares ESG Aware MSCI USA ETF returned an average of 16.2 percent annually in the five years to March 2022. The iShares MSCI USA ESG Select ETF delivered 16.2 percent annualized returns over the same five-year period.
2. It’s not especially expensive to invest in
If you’re buying an ESG fund, the expense ratio on the fund – the cost to invest in it – can be relatively low, depending on exactly which fund you buy. The funds mentioned above have expense ratios of 0.15 percent and 0.25 percent, respectively, making those funds low costs. In practical terms, investors would pay $15 annually and $25 annually for every $10,000 invested.
While even cheaper funds than these exist and deliver strong returns with similar investments, ESG investors aren’t paying a huge premium either.
3. Investor support can help a company thrive
Part of the value for ESG investing is the “feel good” factor in investing in companies that may be helping improve the world, treating their employees well, focused on social justice or simply considering all stakeholders. By investing in ESG stocks or funds then, investors make it cheaper for these companies to finance themselves and therefore thrive.
4 key concerns with ESG investing
The promises that ESG can help change the world are big, and unfortunately those promises are probably bigger than what socially responsible investing can actually deliver. Here are four major concerns with ESG investing and why it may not be the cure-all that’s been promised.
1. You may be paying more to own the same companies
One of the most obvious problems with ESG funds is that they charge a higher expense ratio for what may end up being the same companies in other major indexes or funds. Take the iShares ESG Aware MSCI USA ETF (ESGU) from BlackRock. This popular ETF has about $25 billion under management, as of April 2022. Its largest positions include Apple, Microsoft, Amazon, Tesla and Nvidia, comprising about 20 percent of the fund.
Now, look at what’s in the Vanguard S&P 500 ETF (VOO), which is based on the Standard & Poor’s 500 index and includes hundreds of top American companies. The top eight companies include Apple, Microsoft, Amazon, Meta (formerly known as Facebook), Alphabet, Berkshire Hathaway, Tesla and Nvidia. The stakes in these companies total about 26 percent of the whole fund.
These funds have huge overlap in their top positions, where a huge portion of the fund is held. But ESGU charges an expense ratio of 0.15 percent, while VOO asks 0.03 percent. For every $10,000 invested, that amounts to a difference of $12 annually. It’s not huge in absolute terms, but it adds up and other fund companies may charge more for their variation on the ESG theme.
The backstory: The fund industry has seen shrinking fees for years, as competition has heated up. ESG is an attractive marketing hook because fund managers can boost their fees.
2. Are these companies really doing “good”?
Do the firms among the top holdings in the ESGU fund surprise you? Do Amazon, Microsoft and Nvidia tout themselves as socially responsible investments?
And it might be a similar issue with stocks in other funds. Take another BlackRock fund, the iShares ESG Aware MSCI EM ETF (ESGE), which invests in emerging markets companies. It includes shares of Lukoil and Gazprom, both Russian oil and gas companies. These don’t sound like what people think of when they’re investing in environmental companies.
So yes, while a fund’s investments may not have specific characteristics such as being engaged in controversial weapons or thermal coal, they may not be all that green-friendly, either.
3. Not all ESG funds are the same
While many funds say they include ESG stocks, you won’t be able to judge at all unless you look closely under the hood. Even then, it’s tough to know which businesses a firm is actually involved in, since they’re often large and diverse.
Some funds may own certain kinds of companies that they think are consistent with an ESG mandate. For example, tobacco stocks that may be excluded from some ESG funds may score well on sustainability metrics and be included in other types of ESG funds.
4. Divestment from non-ESG stocks doesn’t solve the problem
ESG proponents suggest that divesting their portfolios from companies that don’t meet the mandate will help, ultimately, put those companies out of business. They see it as a kind of shareholder activism, where investors vote with their dollars. The reality is more complex.
Divesting non-ESG stocks from a portfolio or not lending to them may raise their cost of capital, making it more costly for them to do business. But if the divestment puts downward pressure on the stock, it actually increases the potential return to those who don’t invest according to ESG principles. So, perversely, ESG investing principles may be raising the prospective future returns of non-ESG stocks.
More effective solutions include outlawing or regulating the product, or making it cost-prohibitive to produce.
Getting started with ESG investing
Investors looking to get started with ESG investing have a number of options, including buying individual stocks and ESG funds, as well as working with a robo-advisor that offers ESG options.
If you want to buy ESG stocks, you can invest in exactly the companies that you want, and you can filter out those that don’t meet your criteria. But you’ll need to do the research to find the companies that have ESG cred. One great option here is Interactive Brokers, which provides a detailed ratings system that can help you sort through thousands of publicly traded companies.
However, it’s important to note that you’ll need to do everything yourself, including following your investments over time. You’ll also want to own at least 10 or so stocks so that you’re properly diversified and have reduced your risk.
If you don’t want to screen individual stocks for ESG criteria, a good alternative is an ESG fund. ESG funds include only companies that fit the fund’s criteria for inclusion, so you’ll know that whatever is in the fund passes muster there. Funds are also a great fit for those looking for an easy way to have a diversified collection of ESG stocks without having to do all the legwork.
However, it’s worth noting that not all ESG funds have the same criteria, and some may focus on specific aspects over others (environmental over governance issues, for example). So, you’ll want to understand exactly what you’re buying.
Popular funds include the iShares ESG Aware MSCI USA ETF (ESGU) and the iShares MSCI USA ESG Select ETF (SUSA).
Robo-advisors offering ESG options
If you really want to take a hands-off approach, you can have a robo-advisor manage your portfolio and invest your money. First, you’ll need to find a robo-advisor that offers ESG investing choices – Wealthfront and Betterment are two good options – and then you’ll need to indicate to the robo-advisor that you’re interested in these funds.
From there, the robo-advisor handles pretty much everything else. Just deposit money regularly, and the automated advisor will continue to invest your money according to your preset plan.
Frequently asked questions
What does ESG stand for?
ESG stands for environmental, social and governance, and it’s a type of investing that focuses on those three factors to guide investment decisions.
What is ESG investing?
Proponents of ESG investing focus on three key features of companies (environmental, social and governance factors) to guide their investment decisions. They then invest in companies that demonstrate these values and divest, or sell, companies that don’t meet these criteria.
How is ESG calculated?
Many fund management companies, including those that create mutual funds and ETFs, analyze publicly traded companies on these criteria and construct ESG funds using their stocks. The publicly traded companies need to meet certain criteria, which are often evaluated by third-party analysts, to be included in the funds.
What is the difference between ESG and SRI?
ESG investing focuses more on environmental, social and governance aspects and how the existence of those factors may lead to a stock’s outperformance over time. ESG investors can then build a portfolio of companies exhibiting those factors. In contrast, socially responsible investing, or SRI, may use ethical guidelines to eliminate certain industries from investment, such as tobacco, alcohol, weapons manufacturers or gambling, for example.
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