What is ESG (Values-Based) Investing?
What Does ESG Even Mean?
There are lots of terms out there that all refer to the same basic idea: aligning your investment dollars with your values. It has often been called Socially Responsible Investing (SRI) and sometimes, Impact Investing. A key strategy of values-based, sustainable and responsible investing is incorporating environmental, social, and corporate governance (ESG) criteria into investment decisions. The term ESG first appeared in 2005 in a landmark study entitled “Who Cares Wins.”
In contrast to ESG, SRI investing (Socially Responsible Investing) is typically more focused on "negative screens", meaning specifically excluding certain factors from a portfolio (often alcohol, tobacco, firearms, etc). ESG investing, on the other hand, is less about negative screens and more about choosing companies that fit the ESG criteria.
ESG has gained momentum in the last 4-5 years, in part because there have been several studies showing that good corporate sustainability and governance is associated with good financial results. Not surprisingly, it's always easier for an idea to take hold if the financial incentives line up with the values incentives. ESG factors such as environmental friendliness are considered factors in the longevity of a company. In other words, companies that follow high quality environmental, social and governance standards are more likely to outperform their peers in over the long term.
Environmental risks can refer to those risks created by business activities that have actual or potential negative impacts on air, land, water, ecosystems, or human health. ESG factors for individual companies include managing resources and preventing pollution, reducing emissions and climate impact, and executing environmental reporting or disclosure. Environmental positive outcomes include:
avoiding or minimizing environmental liabilities,
lowering costs and increasing profitability through energy and other efficiencies, and
reducing regulatory, litigation and reputational risk.
Social risks typically refer to the impact that companies can have on society. This includes company activities such as promoting health and safety, encouraging labor-management relations, protecting human rights, and focusing on product integrity. Social positive outcomes include:
increasing productivity and morale,
reducing turnover and absenteeism, and
improving brand loyalty.
Governance risks concern the way companies are run as a business. This includes corporate brand independence and diversity, corporate risk management and excessive executive compensation. It can include activities such as increasing diversity and accountability of the board, protecting shareholders and their rights and reporting and disclosing information. Governance positive outcomes include:
aligning interests of shareholders and management, and
avoiding unpleasant financial surprises.
ESG investing lines up well with general trends in the marketplace that tend to favor smarter, cleaner, and healthier products and services. Additionally, ESG investing offers individual investors a way to "vote with their dollars." Many investors, especially Millennials, are interested in more than just the financial outcomes of their investments. They are often also very interested in the impact their investments have on the world.
How to Incorporate ESG Investing
Is ESG Investing right for you? There's no one right answer. ESG funds do typically come at a higher price. They have to spend more time and resources to be sure the companies they invest in are conforming to the ESG principles.
Investors should consider all costs (explicit and implicit) associated with ESG investing approaches:
The screens adopted to address sustainability issues are a cost to a portfolio
Some high-performing stocks may be excluded
Diversification may be reduced by screening out stocks
If you want to start investing with funds that apply ESG principles, it's still important to diversify. The "don't put all your eggs in one basket" idea still applies! You can find diversified funds that invest in a broad range of industries that still hold to ESG investing. In fact, many of the same investing principles apply to ESG investing. You'll want to look for low-fee, transparent funds from reputable companies. And you still need to take your risk tolerance and time horizon into consideration.
It's important that the fund starts with a robust investment framework, then overlays the considerations that represent the views of sustainability-minded investors. This allows for a cost-effective approach that provides investors with the ability to pursue their sustainability goals without compromising on sound investment principles or accepting lower expected returns.
There are more than 275 ESG mutual funds and ETFs available to U.S. investors. Morningstar gives sustainability ratings and evaluates funds based on the ESG profiles of the companies in a portfolio.
Resources for ESG Investing
Where do you find sustainable funds and ESG resources? A good starting place is the US Forum for Sustainable Investing (USSIF)'s list.
You should be aware that some of the funds on the USSIF list are load funds (additional fees), and others have very high minimum investments ($1 million). Be sure to focus on no-load funds that you can invest in. And if you click on the ‘account minimums’ tab, it’s easy to see which funds are available for as little as $1,000.
The key takeaway for investors is that investing well and incorporating values around sustainability need not be mutually exclusive. If you want to learn more about incorporating ESG principles into your own investments, you can always schedule a meeting with me to talk more about your situation.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Alyssa Lum, and all rights are reserved. Read the full Disclaimer.