Investing strategies that focus on investments in companies that seek to make a positive, long-term impact on the environment, employees and communities have continued to grow in popularity. The primary appeal of ESG (environmental, social and governance) investing – along with related approaches that include SRI (socially responsible investing) and impact investing – is that investors potentially could earn favorable returns while supporting companies that are contributing to society.
To help you make informed investment decisions, here’s a brief summary of ESG investing:
What is ESG investing?
In addition to traditional financial analysis, ESG investing includes an in-depth review of non-financial factors to identify investment opportunities. Environmental factors include a company’s ecological stewardship and focus on waste and pollution, resource depletion, greenhouse gas emissions, deforestation and climate change. Social factors include how a company treats its employees, the diversity of its workforce, and its contribution to local communities. Governance factors include corporate policies and governance, executive remuneration and board diversity and structure.
What has been the trend in ESG investing?
Over the past 15 years, there has been substantial growth in ESG investments. A key reason is the change in investor demographics. More women and millennials are inheriting assets and have a greater interest in being socially responsible with their wealth. The US SIF: The Forum for Sustainable and Responsible Investment’s biennial 2018 “Trends Report” estimates that investments in ESG, SRI and related approaches increased 38 percent over the past two years to $12 trillion – or more than 25 percent of the $46.6 trillion in total assets under management in the U.S. Larry Fink, founder and CEO of Blackrock, which manages more than $6 trillion in assets, has been a vocal proponent of ESG investing. In his annual letter to CEOs over the past couple of years, he has stressed that his firm will continue to look closely at ESG criteria when allocating the company’s capital.
What are the challenges in ESG investing?
Understanding ESG has been challenging because each industry and business is different. So too are the methods and measures for applying ESG criteria. Moreover, ESG ratings are based on what a company chooses to disclose and not based on independent, third-party research, which can leave room for “greenwashing” (a play on the word whitewashing – or hyping environmental benefits). Several organizations have established standards that provide a framework for how a company can disclose ESG information, such as the Global Reporting Initiative and the Sustainability Accounting Standards Board. Disclosure is voluntary, however, and there is no organization to provide oversight or validate company claims.
There are also differences around ESG scores and how criteria are weighted. For example, one well-known technology company earns high ESG marks for its plan to be carbon negative by 2030, while another ESG index would not rank the company at all because of low gender diversity.
Cost is another challenge, as many ESG funds or exchange traded funds (ETFs) have higher management fees than their traditional counterparts, which can be a drag on performance. Additionally, most of these funds and ETFs have a limited history of three years of less.
Is ESG right for you?
It depends on client preferences and values. Given the current challenges, building an optimal ESG-only portfolio could prove elusive as evaluation criteria remain unclear and reporting standards evolve. Nonetheless, as fiduciaries, we need to stay current on developments in ESG investing to understand and communicate its benefits, drawbacks and risks. Researching companies with a layer of ESG could mitigate certain risks and meet specific client needs, but only if some of the aforementioned challenges are addressed.