What is ESG investing?

What is ESG?

ESG stands for Environmental, Social, and Governance. Many different issues and causes fall under this umbrella, from climate change to corporate policy. These are called ESG factors.

ESG investing focuses on how (or if) companies respond to these factors. For example, do they work to make their business more environmentally friendly? Are they taking steps to combat human rights issues? What measures do they take against poor corporate governance?

ESG factors are used to evaluate sustainability and determine which companies and businesses will succeed – and which ones will fail. In theory, a high ESG score or rating indicates a higher likelihood of long-term success while a lower score indicates the opposite.

The goal of ESG investing is to reduce risk and improve returns by considering relevant non-financial factors that affect business. The idea is that companies with policies in place to address environmental, social, and governance factors are more competitive than those without. They’re more responsible and responsive, making people want to support them.

There are a few ways to choose investments with this strategy. Many ESG investors use ratings to compare opportunities and then pick causes they care about from the top choices.

Social criteria

Social factors are all about human rights and equality. When evaluating a company on its social impact, you’ll be looking into internal conduct as well as community impact.

Here are some questions you can ask about social criteria:

• Employee compensation: Are employees paid fairly for their work and compensated similarly despite differences in gender, ethnicity, etc.?
• Diversity: Does the company employ people of many different backgrounds, from entry-level positions to management?
• Philanthropy: How does the company give back to the community and make a positive impact?
• Safety: How does the company create a safe workplace and prevent injuries? What data security measures does it have in place?
• Supply chain: Is the company forthcoming about its supply chain practices from sourcing to manufacturing?

As an ESG investor, you’re interested in how a company treats its people and manages its product. Do people want to work there? Are its practices safe and ethical? Transparency is key.

Social criteria are difficult to evaluate on your own but annual reports can be helpful.

Governance criteria

Governance factors evaluate how a company is run. ESG criteria look at business ethics, responsibility, duty to shareholders, etc.

Here are some example questions to ask to measure governance:

• Leadership: What are executives paid, what is the composition of the board, and how are new executives and board members chosen?
• Compliance: How does the company conduct internal audits and how often?
• Corruption: What measures does the company take to prevent and combat corruption?
• Shareholder rights: What role do shareholders play in decision-making?
• Political involvement: If the company makes political contributions, how much does it contribute, and to which platforms?

There are a lot of different ways companies can be shady about what goes on behind closed doors. Governance encourages accountability and preventative action.

Often, companies with high governance metrics are more responsible and better protected against threats. This can lead to increased profits and longevity.

Environmental, social, and governance investing varies from other kinds of sustainable investing but falls into the same category as ethical investing and impact investing.

Some of the most common types of sustainable investing include:

• Socially responsible investing (SRI)
• ESG investing
• Impact investing
• Green investing
• Community investing

ESG investing and SRI are most commonly confused. Here are some important differences.

ESG vs. SRI

Although ESG investing and SRI are closely related and often overlap, these are two distinct investment strategies.

ESG scores different investments based on environmental, social, and governance criteria. ESG itself is a system for grading investment opportunities, not a strategy. ESG investing is a strategy that uses the ESG system along with financial information to inform decisions.

SRI, or socially responsible investing, is an investment strategy that focuses on the social impact a company has on the world. This differs from ESG investing in a few ways:

• ESG investing focuses broadly on impact while SRI focuses on social.
• SRI screens for companies that meet standards and chooses between these while ESG investing uses metrics to grade investments and chooses from the highest scores (typically).
• ESG integration is common in SRI but ESG uses its own metrics for social impact.

SRI and ESG investing are often used interchangeably, but they’re not technically the same.

If your head is spinning at the thought of doing your own ESG research, you can relax. There are many ways to get started with ESG investing that don’t require so much work on your part.

ESG funds

Rather than choosing individual investments, you can start with ESG funds. These are portfolios of pre-selected assets optimized for returns and sustainability.

Many investment firms have ESG mutual funds and ETFs. Here are some examples.

• TheAspiration Redwood Fund – This fund invests in companies with high potential for growth and focuses on ESG factors including climate change and racial and ethnic diversity. It uses a “pay what’s fair” fee structure and requires a $10 minimum deposit.
  • Read more: Aspiration Review: A Neobank Working for Social Change
• Dow Jones Sustainability Index – This fund is comprised of the top 10% of companies in the S&P Global Broad Market Index with favorable ESG and economic prospects. This includes information tech companies, healthcare companies, financial firms, and more.

Of course, every fund is different. Before choosing one, you’ll want to look into how it selected investments to make sure you’re aligned. From there, you’re diversified and invested in multiple sustainable assets.

ESG scoring platforms

To find out if a fund or investment is right for you, there are platforms you can use to screen ESG ratings.

MSCI, for example, is a research firm that provides tools and analyses for finding assets to invest in. You can use the MSCI ESG Fund Ratings Search Tool to search specific mutual funds and ETFs, the ESG Ratings & Climate Search Tool to search individual companies, and the Index Profile Search Tool to search indices.

Research platform Morningstar also provides ESG data to managers and individual investors with its Sustainability Ratings. Its Sustainability Ratings go into detail not just about a company’s top ESG strategies but also about its carbon metrics, overall risk, history of controversial incidents, and more.

Pro tip: ESG ratings are helpful, but you should always dig a little deeper to find out what a business is actually doing and why it received its score.

Investing platforms

Many brokerages and robo-advisors make it easy to build or customize dedicated ESG portfolios. These may be referred to or found under socially responsible portfolios.

Wealthfront

Wealthfront is a robo-advisor known for its unique approach to customization that ensures your portfolio is aligned with your goals. ESG investors can choose the Socially Responsible portfolio rather than Classic if they want a portfolio made up of sustainable investments. Both options offer benefits like tax-loss harvesting

Benefits of ESG investing

Both individual and institutional investors can take part in ESG investing, and there are many potential benefits to doing so.

ESG investing is about more than just investing for profit, as many traditional investment strategies focus on. By putting your money into companies with environmental, social, and governance policies, you can directly support causes you care about like the fight against climate change or the global reduction of carbon emissions. If you believe in what a company is doing and want to see it succeed, invest in it.

And by putting your investment dollars into businesses and brands with forward-thinking initiatives, you might be able to earn more profit. A major component of ESG investing is reducing risk, and this can translate to higher earnings.

Though ESG investing can be profitable, this is not guaranteed. Some ESG funds underperform against standard index funds and sometimes it can take a while for ESG investments to grow.

It’s also very easy for companies and funds to make claims about their responsibility without backing them up. For example, a business can claim to make “eco-friendly” products, but if you do a little digging you find that its products use only 5% recycled materials.

And there’s a good deal of grey area when it comes to ESG ratings, which can be fairly subjective. For instance, can a company with a history of unethical hiring practices really be considered “socially conscious” if it donates profits to the community?

Ultimately, this is a decision you have to make. ESG investing is a strategy and it’s not going to be a good fit for every investor.

Those interested in ESG investing need to decide a few things before getting started. Here are some questions to ask yourself.

• Will you consider ESG factors above financial factors or vice versa?
• Which ESG issues are most important to you?
• What is your risk tolerance and how much of your portfolio will you dedicate to ESG?
• Which platforms do you trust for ESG ratings and recommendations?

ESG integration is not all or nothing. You don’t have to replace all of the assets in your portfolio with sustainable alternatives to take part in ESG investing.

If you can stomach a bit of risk and you’re willing to do the extra legwork required for ESG integration, maybe give it a shot on a trial basis. Allocate a small percentage of your portfolio to ESG and keep an eye on it.

If you’re passionate about something, do something about it. Maybe that’s investing and maybe it’s not. That’s your call, but you should understand your options.

Talk with a financial advisor if you’re not sure what investment strategy is right for you.

Read more: Should I get a financial advisor?

ESG investing is about making investment choices based on ESG factors, which are used to measure sustainability. Like any investment strategy, there are advantages and disadvantages to this approach. And while investments with high environmental, social, and governance marks might outperform others in some cases, it’s important to be aware of ESG risks too.

Whatever you decide, don’t make any financial or investment decisions because you feel pressure from someone else. You are the one who has to live with your choices. If you’re unsure, talk to a professional.