ESG Investing: Making Money and Making a Difference
People are becoming increasingly aware of local, national, and global issues such as climate change, social issues, pollution problems, hunger, and poverty. This heightened awareness has led to a desire among people to do more to be a part of the solutions and make a difference in the world. With all the conversations around these world issues, it is no surprise that there have been more discussions around ESG investing. Have you ever wondered what it would look like to make an impact while investing and if it is possible to make money and a difference? We will examine what ESG investing strategies can look like, what it means to utilize ESG focus as part of your investment strategy, and its effects on your investment decisions.
What is ESG Investing and why does it matter?
ESG is also commonly referred to as ‘socially responsible investing’ or ‘impact investing’. ESG stands for Environmental, Social, and Governance investing and categorizes the many focuses they have underneath them.
- Environmental focuses on being mindful of areas such as climate change, water use, and pollution. For example, policies around this may focus on improving processes to reduce or stop pollution or updating procedures to use less resources from the environment.
- Social concerns a mindful workplace regarding safety, human rights, diversity, and anti-bias issues. Taking an active approach to these areas could reduce a corporation’s risk of lawsuits.
- Corporate Governance focuses on executive compensation, board independence, and anti-corruption policies.
When corporations utilize these areas of ESG in their policies and procedures, they can mitigate risk, help the environment by using fewer resources, and impact their communities. An example of an ESG investment might be selecting a company focusing on generating renewable energy. The history of ESG investing strategies dates back to the 1970’s, but their popularity has been steadily increasing, especially after the 2020 pandemic. More foundations and government agencies are prioritizing these issues, and there has been a significant rise in assets invested in ESG strategies. PwC, one of the big four firms dedicated to measuring ESG investing, has estimated that an increase in assets invested in ESG-focused strategies is set to reach $33.9 trillion by 2026. We will continue to see companies facing increasing pressure to adopt ESG criteria in their policies, more investment options becoming available, and more investors focusing on ESG.
How Popular is ESG Investing? For many individuals, their investment portfolios are their most significant source of wealth, and being able to align your investments to see growth in your accounts plus have an impact is becoming more of a forefront focus for many investors. Natixis Investment Manager conducted a 2019 study on retirement accounts called “Retirement Reality Check.” A survey of 1,000 workers in company-sponsored retirement plans found that “75% of participants believe it is important to make the world a better place while growing their personal assets.” Also, a report by PwC has determined that “8 of 10 U.S. investors plan to increase their allocations to ESG products over the next two years.”
"8 of 10 U.S. investors plan to increase their allocations to ESG products over the next two years."
How does ESG investing work?
According to The Sustainable Investment Forum, “there is no single approach to sustainable investing, there is no single term to describe it.” I feel that when it comes to ESG investing strategies, you can think of them in terms of how different values and impacts are affected by the companies you are supporting through your investments. You can use that, along with traditional portfolio-building strategies, to determine what ESG Investing solutions work best for you.
With ESG investing, funds and investors can build out their strategies in various ways, providing them with multiple options. Let's look at some ways investment firms may decide to include companies in their funds. Part of the ESG criteria screening is reviewing company policies by looking at their ESG initiatives and whether they're actively making improvements, whether their corporate philosophies align with ESG values, or whether the company's business practices have adverse effects. With this, not all ESG investment options are created the same way, and investment managers have various strategies to integrate ESG into their selection of companies to invest in.
Asset managers may choose companies with strong existing policies and procedures that positively impact ESG areas when making investment decisions. These companies are then included in their portfolios. Another strategy asset managers will take when picking companies to invest in is excluding companies with poor “ESG track records.” There are also strategies of using both benchmark corporations and companies that are “investment opportunities based on ESG issues.” This is a reflection that shows different funds can have varying levels of impact.
The management companies of ESG funds may also actively advocate for change to affect those three target areas positively. Adding this level of advocation for companies to improve their practices and policies is an added benefit to investors by adding another level of managing risk. They would actively bring awareness to issues within the company policies and use their proxy votes to support the positive changes or remove negative policies that will better the company's policies and practices around governance, environmental, and social risks. Since these fund companies typically own more shares, they have a more significant impact when voting to make these changes.
The Pros and Cons of ESG Investing Strategies
When making any investment decision, it is essential to consider the pros and cons. ESG investing strategies are no different and have their own set of pros and cons.
The pros of ESG investing include:
- You will be getting to make an impact within communities locally and globally.
- By aligning with your values, you can feel more connected to your investment portfolio, making it more than just numbers.
- ESG funds offer the same risk management, high quality, and sector performance as conventional funds for most areas. The only difference? ESG funds may also make a positive impact on society and the environment.
- ESG investing may provide downside protection due to strong policies and oversights that are in place.
The cons of ESG investing include:
- There are fewer investment options than conventional funds, especially in specific segments. For example, with value funds, it may be difficult to find options that are fossil fuel-free and can also perform.
- The expense ratios may be higher on ESG funds than on conventional funds.
- There is no standardized system for data providers to score ESG data, which causing inconsistent scoring across different rating companies. For example, one rating company may give it a more positive ESG effectiveness score than another.
What Does the Performance of ESG Investment Funds look Like?
One of the most frequently asked questions about ESG investment strategies is how they will affect the performance of the portfolio and whether they will yield lower returns compared to conventional funds. In 2021, the NYU Center for Sustainable Business conducted research on 1,000 studies on the performance of ESG performance data. Their data focused on actively managed equity investment strategies. The study found that 58% were positive, 13% were neutral, meaning they performed better or the same as conventional investments, 21% were mixed between positive, neutral, or negative performance, and 8% showed negative performance compared to conventional investments.
The study's findings emphasized the importance of strategy and risk in investing. Long-term focused investing was found to be more likely to result in positive or neutral performance compared to conventional investments. The research conducted at NYU also indicated that sustainable initiatives in corporate policies can enhance areas such as risk management and innovation. Giving more attention to risk management and fostering innovation has a positive impact on companies' financial performance.
MSCI has conducted a 30-year study comparing its ESG index, the MSCI KLD 400 Social Index, to its conventional index, the MSCI USA Index. Their analysis reports that the ESG index has outperformed the conventional index by 0.36%.
You don’t have to sacrifice your performance and growth of your portfolio to incorporate ESG investing strategies. I think it’s important to keep an open mind about your options and understand what values are important to you to focus on. There may be some issues that are more important for you to focus on that may not have as many investment options and may perform negatively compared to a conventional fund in a similar sector.
What could a more impactful approach to investing look like for your portfolio?
Approaching an ESG investment strategy is similar to approaching a conventional one. Determining the appropriate level of risk by knowing the time horizon for your investments and what you are willing to handle in terms of risk when it comes to market fluctuations. As with the weather, there will always be storms in the markets. However, it’s important to remember that after the storms, it’s calm. Like conventional investing, knowing your risk level helps determine the appropriate allocation level for you. When building an ESG investment strategy, the additional decision is what level of ESG incorporation you want in your portfolio.
There are also several ways to incorporate ESG investing that aligns with your values and needs. One option is building an ESG-only portfolio where the priority is impactful investing. By incorporating an ESG-only portfolio, these issues are at the forefront of investment decisions, and it’s most important to choose investments that positively impact the various areas of ESG. This is the type of portfolio where you may see some trade-off in performance due to having your own stringent policy. However, this may be an option where someone would feel they are being the most impactful.
Consider a hybrid model as another option, where you can invest in both ESG and conventional options. This approach allows you to balance your investment strategy by including ESG-focused funds and conventional funds. This balanced approach allows you to focus on growth while still giving some attention to ESG areas. It's important to remember that this is personal finance. That means there is no right or wrong answer when you're making these decisions. It's a matter of what works for you, your values, and your needs best. Something to reflect on as you're navigating this is to ask yourself, will these investments make me feel differently.
Should I discuss ESG investment strategies with my financial advisor?
If you decide ESG investing is the right option for you, talking to your financial advisor is a great place to start. It’s essential to have an open discussion with them on why impactful investing is important to you and also ask why impactful investing is important to them. You can also ask how they chose their investment strategies for ESG investing. Also, ask your financial advisor how their impactful investment strategy performance compares to their conventional investment strategies. Will your investments have a real impact? Finally, ask yourself if these investments will make you feel differently.
When investors incorporate ESG into their investment philosophies and portfolios, they experience an emotional impact. It is important to think about your values and your goals for your money.
Sources:
PWC: Asset wealth management revolution ESG | PwC
NYU Study: ESG Paper Aug 2021.pdf (nyu.edu)
UN - Department of Economic and Social Affairs: | Sustainable Development (un.org)
Netixis ESG Retirement Study: 2019-defined-contribution-plan-participant-survey (natixis.com)
Author: Jen Koch, CFP® | Allegheny Financial Group | June 2024
Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered broker/dealer. Member FINRA/SIPC.
