There’s no doubt that the world has changed markedly during the 21st century, from how we interact with one another to the social, economic, and financial challenges that we face in our everyday lives.
Of course, the financial markets also change in line with such trends, which is why ESG (or environmental, social, and governance) investment has become increasingly popular over time.
According to data included in the US SIF Foundation’s Sustainable Investing Overview for 2022, there were $8.4 trillion in sustainable and ESG investments last year, and this number continues to grow exponentially every single year.
But what exactly is ESG and what does it mean, and how can you optimize your chances of success in this burgeoning market niche?
What is ESG?
The basic term ‘ESG’ describes key environmental, social, and governance criteria, which create a framework that’s used by businesses to evaluate their own sustainability. Each of these three criteria can be broken down as follows:
- Environmental: Environment factors focus on the conservation of the natural world, paying particular attention to a business’s carbon emissions and their contribution to air and water pollution. Companies are also appraised on the basis of their approach to waste management and water consumption, while any actions that cause deforestation must also be taken into consideration.
- Social: As for social factors, these examine the treatment of people and key stakeholders who exist both inside and outside the business (namely employees and customers). Remuneration and working conditions are key here, along with employee gender and diversity across the labor force. For International firms, they’ll find that their human rights record is scrutinized both at home and abroad.
- Governance: As for governance, this explores how a company is run at the board level. So, this will include the diversity of board members and their political contributions, along with executive pay figures and their involvement in any large-scale lawsuits. Companies that have a history of internal corruption and lobbying may also be judged negatively, so this is something to bear in mind when considering ESG criteria.
OK, we hear you ask, but what do we mean by ESG investing? Well, this describes a form of sustainable investing that appraises potential assets and funds based on the ESG criteria referenced above.
These factors are then measured against more standard investment metrics such as financial returns, creating a rounded score that helps you to make more informed decisions as an environmentally and socially conscious investor.
Typically, investors with a focus on ESG criteria will target stocks and shares, particularly in fields like renewable energy. Mutual funds are also incredibly popular, and there’s a growing number of such assets available in 2023.
What are the Benefits of ESG Investing?
The performance of mutual ESG funds represents an interesting area of study, with a 2019 white paper compiled by Morgan Stanley exploring this in significant detail.
This paper compared the performance of sustainable ESG funds with traditional alternatives between 2004 and 2018 and found that the former fared slightly better in terms of returns.
JUST Capital also ranked companies based on ESG factors (especially those related to environment and governance) and subsequently created the JUST U.S. Large Cap Diversified Index (JULCD) based on these rankings. This features the top 50% of companies in the Russell 1000 (which is itself a large-cap index), while it has returned 15.94% on an annualized basis since its inception.
Interestingly, the Russell 1000 index has returned just 14.76% on an annualized basis during the same period, suggesting that ESG funds are becoming increasingly generative over time.
It can also be argued that ESG assets offer considerably lower risk. According to the same Morgan Stanley study referenced above, sustainable funds consistently shower a lower downside risk than traditional alternatives, regardless of the underlying asset class.
This is particularly true during the type of turbulent market conditions that we’re experiencing today. In similar circumstances in 2008, 2009, 2015, and 2018, traditional funds experienced a considerably larger downside than those inspired by sustainability, while they showcase a noticeably higher risk and extent of the loss.
Most strikingly, ESG funds and equities even managed to showcase robust and consistent levels of performance through 2020.
A further study by investment research firm Morningstar found that 24 out of 26 ESG funds managed to outperform comparable traditional funds during the first quarter of 2020, while this trend was largely sustained throughout the remainder of the year as the Coronavirus pandemic continued to rage.
ESG Investment Tips for Beginners
At this stage, you should have a better understanding of ESG investment and its core advantages. But what steps can you take to get started in the marketplace? Here are a few to keep in mind:
#1. Decide Whether to Go it Alone or Use Robo Advisors
Ultimately, building any kind of investment portfolio takes time, but it’s fair to say that ESG investing is more complex and involves additional factors that require consideration.
So, although you could go it alone and painstakingly build your own portfolio from scratch, you may instead prefer to leverage tools such as robo advisors to help identify viable opportunities. Robo advisors are digital tools that intuitively build and manage your portfolios based on the information you provide pertaining to risk tolerance and goals.
In the case of ESG investing, they’ll identify opportunities based on key ESG criteria and your underlying appetite for risk. Not only are such advisors highly accessible and smart, but they also tend to be much more affordable than in-person or corporeal wealth management firms.
#2. Be Mindful of Stocks and Equities
There’s always a strong focus on mutual funds in the world of ESG investing, and it’s generally a good idea to avoid allocating too high a percentage of your portfolio into stocks.
Regardless of the precise contribution that equities make to your portfolio, however, you must be selective when targeting standalone stocks. It’s definitely worth prioritizing socially-conscious businesses that produce regular impact reports, which tend to shed light on their ESG-related initiatives and approaches to minimizing carbon emissions.
You should also consider using third-party data from resources such as Glassdoor.com, which will provide insight into employee satisfaction, the average employee remuneration, and how this compares with the industry average.
Be sure to combine these insights with more traditional factors like net income and revenue, too, so that you can ultimately arrive at more informed decisions.
#3. Consider Your Own ESG Criteria
As we can see, ESG is defined by some incredibly clear boundaries, which help to set the practice apart from much broader concepts such as ethical and socially responsible investing.
However, there are a finite amount of metrics included in ESG reports, and you may have other values and principles that exist outside of such criteria. In this case, you’ll want to factor these into any fund or equity appraisal, ensuring that you build the best and most relevant portfolio over time.
Of course, this will also broaden your horizons and potentially unlock more investment opportunities, translating into higher returns and profitability over time.
