What Is ESG Investing and How Does It Compare?

Learn about socially responsible investing strategies like ESG investing that are designed to invest in companies that have a positive impact on society and how this affects financial returns.
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ESG-Investing

Your money's important, but so are your principles. Is there a way to invest that honors both priorities?

That's where ESG investing comes into play.

ESG investing is an approach that tries to invest in companies with positive ethical characteristics while still attempting to earn competitive returns.

If that sounds like an admirable goal to you, ESG investing may be worth looking into. As you consider it, though, you should recognize that there are some twists to it.

When it comes to ethical standards, not all ESG investment approaches pursue the same goals.

Also, there may be an added cost to ESG investing. If you invest according to ethical principals rather than purely based on a profit motive, there may be times when you have to accept lower returns.

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What is ESG Investing?

"ESG" stands for "Environmental, Social and Governance." Those are three areas of ethical standards to which this approach seeks to apply investment decisions.

  • Environmental investment can mean favoring companies seen as having a positive impact on the environment, or at least avoiding those with an especially negative impact.

    So, this could mean investing in a company whose products use eco-friendly technologies, such as electric vehicles, or it could mean refusing to invest in companies whose operations create an overly large amount of pollution.

  • Social investing can mean looking for companies which actively promote policies such as inclusion and social justice, or avoiding companies with negative track records in those areas, at minimum.

    For example, this could mean seeking out companies whose board memberships are built around certain diversity standards. It could also mean avoiding companies with an ongoing history of discrimination complaints.

  • Governance

    investing refers to how a company is run. The guiding principal is that boards and executives should be accountable to the company's investors, employees and the community at large. A big issue within governance is how to hold company executives accountable.

    So, investing according to governance standards might include favoring companies where the majority of directors on the board are independent of day-to-day company operations and avoiding companies where that is not the case.

ESG investing is a fairly recent way to describe what has been known for decades as socially responsible investing.

Investing according to ethical principles is not simple. People have different opinions about what is ethical - not to mention the fact that these issues are constantly evolving. Environmental science, social justice issues and corporate governance theory all raise somewhat different questions today than they did 25 years ago, and they will probably introduce new themes in the next 25 years.

Besides the issue of what ethical standards an ESG approach pursues, a key debate about socially responsible investing is whether it has a negative or positive impact on investment returns.

Does ESG Investing have Good Financial Returns?

You might assume that you would have to give up some financial return in order to invest according to your principles. However, some promoters of ESG investing insist that the approach can actually improve investment returns.

One school of thought is that, when you restrict choices or make decisions based on anything other than the investment merits of a security, it's bound to mean missing out on some return opportunities. That doesn't mean ESG investing is a bad strategy. It simply means acknowledging the trade-off between ethical principles and profit motive.

The opposing school of thought is more of a have-your-cake-and-eat-it-too theory. This presumes that pursuing sound ethical principles helps a company succeed in the long run. Therefore, this argument says that selecting investments based on ESG standards can yield better returns over time.

It's worth acknowledging that each of these schools of thought has a point. It's just simple logic that restricting an investment approach in any way is going to mean missing out on some return opportunities. On the other hand, some irresponsible corporate behavior - say careless pollution or employment discrimination - is likely to incur liability and damage the company's reputation.

Rate of return for ESG investments

There have been a variety of studies done on the relationship between ESG investing and financial returns. These studies have reached opposing conclusions, some making the case that ESG investing hurts rates of return and some arguing that it helps them.

The United States Department of Labor has added to the confusion by issuing different guidance over time as to whether socially responsible investing is an appropriate strategy for employee benefit plans. However, when it comes to your personal investments, you are free to invest as you see fit.

Besides affecting the nature of your investment choices, ESG investing may also be more expensive. Financial firms often view ESG approaches as premium products and give them higher fees.

If you're considering ESG investments, you should be willing to accept at least the possibility that the approach may cost you some rate of return, at least at times.

After all, investment and economic conditions vary, sometimes favoring one type of investment and sometimes others.

The time horizon of different investors also varies. A 25-year old typically has more time to see how ethical standards impact investments than someone who has reached retirement age.

Also, there's the simple fact that, for better or worse, the impact of socially responsible investing must vary simply because there are different approaches to it.

Types of Socially Responsible Investing

A big reason why it's impossible to say for sure what impact ESG standards have on investment returns is that those standards can be applied in a variety of different ways.

Below is a run-down of some of the key differences.

Different ethical priorities

Just the name "ESG investing" is a clue that there may be different types of ethical standards at work. After all, environmental, social and government issues each involve different things.

Some ESG approaches may attempt to consider all three types of standards while others may focus on just one.

Even within each type of standard, there are differences of opinion as to what constitutes responsible corporate behavior. Each person is free to choose which set of standards appeals to them most ethically, but they can't all claim to yield the best investment results.

Inclusion vs. exclusion strategies

Broadly speaking, there are two ways you can align a portfolio with a set of ethical standards. You can seek out investments specifically because of their positive impact or you can avoid investments because of their negative behavior.

Including investments because they promote certain ethical goals is sometimes known as impact investing. Impact investors hope the companies they put money into will have a positive effect on society. Think of this as rewarding good behavior.

The other approach involves excluding investments that violate certain ethical standards. This can be just because of the business they're in (for example, different people may object to gambling, alcohol, firearms, etc.) or their business practices. Think of an exclusion strategy as punishing bad behavior.

Mutual fund vs. custom portfolio

There are a variety of mutual funds that follow ESG approaches, and you can also assemble a customized portfolio based on ESG guidelines.

Mutual funds are a cost-efficient approach for most investors. It generally takes hundreds of thousands of dollars to get a professionally managed, separate portfolio while you can invest in a fund with less than $1,000.

The only catch is that with ESG funds you have to accept the generalized set of ethical standards set up for the fund, as opposed to being able to customize your own standards.

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How to Implement an ESG Investment Approach

If you like the idea of ESG investing, the following are steps you can take to incorporate it into your investment approach:

1. Clarify your goals

Ethical standards are not generic. There are a great many ESG issues and different opinions on those issues.

Just think about the arguments people have over global warming, social justice, personal behavior and the responsibility of corporations to the community. Now picture each side of those arguments as a different set of ESG investment standards.

You need to decide what your ethical priorities are so you can find an investment approach with ESG criteria that match up with your goals.

Speaking of goals, another thing you should decide going in is to what extent you are willing to sacrifice investment returns for your ethical standards. Your thoughts on that trade-off should guide both how restrictive an ESG approach you are willing to take and how you will evaluate the performance of that approach.

2. Choose a financial professional familiar with ESG investing

This article just scratches the surface of how complex ESG investing is. If you work with a financial advisor, it's important to find someone who has experience with and an understanding of ESG investing.

It's not simply enough to identify an investment product that says it takes an ESG approach. Knowing what the ESG criteria are, how they are implemented and the product's track record are also important.

3. Measure financial performance relative to similar ESG approaches - and non-ESG approaches

Performance measurement is an important part of any investment program. You should consider past performance when choosing a product, and then you should periodically review performance to see if the product has delivered as expected.

Since ESG criteria are bound to affect performance to some degree, you should measure performance of ESG funds relative to the performance of funds with similar socially responsible investing guidelines.

Comparing to other ESG products is a good way to measure peer-group performance. However, you might also want to compare performance relative to non-ESG approaches, such as market indexes like the S&P 500. That might give you a feel for the extent to which ESG investing is affecting your results.

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