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What Is Sustainable (ESG) Investing And How Does It Work?

Lauren Nowacki10-minute read
February 10, 2021

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Thanks to the internet and 24-hour news cycles, we’ve had more media exposure to global environmental and social issues than ever before. From news footage of oil spills, wars and wildfires to the countless videos of racial injustice on social media, younger generations have grown up aware. At the end of the day, more people want to put their money somewhere they feel it makes a difference. Environment, Social and Governance (ESG) investing helps them do just that, while also gaining financial returns.

What Is ESG?

ESG is an acronym used to describe an approach to investing that takes these three factors into account: Environment, Social and Governance. An ESG investor asks:

  • How does a company impact nature and the environment?
  • What is this company's stance on social issues?
  • How does the company treat its employees?
  • Is this company run ethically?

Someone who wants to invest their dollars responsibly will research companies and mutual funds that seek to address these issues. Keep reading to learn how to make ESG a part of your investment strategy.

What Is ESG Investing?

ESG investing is an investment strategy for analyzing and choosing stocks based not only on the potential financial returns for the investor, but also the environmental, societal and corporate behavior implications they carry as well.

If Warren Buffett's advice is "Never invest in a company you don't understand," then an ESG investor's approach is "Invest in companies that make a difference." People interested in ESG investments want to make investment decisions that result in positive change for the world as well as financial returns for themselves.

Reasons for investing can range beyond turning a profit. An ESG investor believes a responsible investment is a good one. Whether you want to invest in alternatives to fossil fuels or companies treating COVID-19, there's likely an ESG investment for you.

The core of ESG investing is a belief that good environmental, social and governance practices are good for business.  An ESG investor believes doing good and financial success aren't mutually exclusive.

The ESG framework can makes it easier to find investments that appeal to you and align with your values. For example, if climate change is a big issue for you, the ESG framework will help you find environmentally responsible companies to invest in. This helps keep your money out of businesses and practices that contribute to climate change.

How Does ESG Investing Work?

Using values to guide your investing can make for a solid long-term investment strategy. How does that work? Non-ESG investors may only look at shareholder value. An ESG investor is considering the big picture.

The Future

ESG investors are looking at the future. Climate change has had disastrous effects on economies worldwide. These effects will compound over time. Investing in companies that address carbon emissions or waste can lead to positive change and a profit in the long run.

By looking at outside forces, like the environment, investors are mitigating risks. They're bolstering companies trying to solve problems that could wreak havoc. With new problems come new investment opportunities. There are companies right now creating tech to fight wildfires. An ESG investor knows these are solutions the market demands.

Corporate Integrity

ESG investors believe in integrity. They're looking for companies that treat their employees well. They want employees to be happy for their own sake. But also, studies have shown happy employees are more productive. They put more into their work.

Diverse and inclusive workplaces attract brilliant minds. Innovation and progress come out of companies where employees are thriving. These people aren't just punching the clock. They're diving in because they know their employer has their back.

Companies with happy employees have less turnover. Less turnover means companies spend less resources on recruiting, hiring and training. With less time and money spent filling vacated seats, they can focus on growing their business.

Sustainability

Instead of chasing short-term profits, companies governed by executives thinking many steps ahead are a huge part of ESG investing. When a business only grinds for a quarterly profit, there are blind spots. They're working in tunnel vision.

Research supports the view that ESG companies are well run, and therefore sustainable for the long-term. They're not being led by a short-term CEO with a golden parachute. They're led by a group of people with pride and vision. They're aware of their surroundings, they're prepared, and they know how to pivot when needed.

ESG Vs. SRI Vs. Impact Investing

The term “sustainable investing” is a broad term for a variety of investment philosophies that consider the positive impact an investment can bring to the investor’s pocket and to the environment and society as a whole.

A Brief History

The concept of ethical ownership dates back thousands of years. Ancient Jewish and Islamic laws set up ethical guidelines for ownership well before the Dow Jones was created. Throughout national and global historical events, this concept took form – from prohibiting participation in the slave trade, to divesting in weapons manufacturers during the Vietnam War, to becoming more aware of the impact investments had on the plant after Chernobyl, popularity in socially responsible investing grew.

Socially Responsible Investing (SRI)

SRI is the original idea of investing for social impact as well as returns. This philosophy uses more of a negative screening for investments. SRI investors may avoid investing in companies that engage in certain production, services or behaviors that conflict with their personal or political beliefs. Profitable returns run second only to a clear conscience, which is the top consideration when practicing this type of investing.  

Impact Investing

The Global Impact Investment Network (GIIN) defines an impact investment as those made “with the intention to generate positive, measurable social and environmental impact alongside a financial return." While ESG investing applies environmental, social and governance principles only to profitable investments (because non-profitable ones were already weeded out), impact investing implements those principles with profitability at the same time, earning financial returns while generating positive environmental and social impact. For example, high-net-worth individuals can throw millions of dollars at an issue, while lower-net-worth investors can pressure institutions and their peers to come together to invest or divest, all while making a profit.

Types Of ESG Investing

ESG is a wide-ranging field. An investor may lean more toward one factor over the others. When growing your investment portfolio, look at these ESG issues and see how they can fit in with your decision-making.

Let's break it down by each ESG factor.

Environmental

For investors looking at companies' handling of the environment, there are a lot of ways to invest. You could look at companies addressing environmental risks or companies that embrace sustainability as part of their culture. Here are examples of what companies do to champion the environment:

  • Produce alternative energy components, like wind turbines and solar panels
  • Develop new tech for things like food production, water treatment and improving air quality
  • Reduce energy consumption, waste and pollution
  • Produce alternatives to animal-based products
  • Work to preserve natural resources
  • Create goods and services that correspond with the effects of climate change

Sustainable investing means two things for an ESG investor: is the company good to the environment, and is it financially sustainable? These two go hand in hand. In the mind of an ESG investor, if a company wants to remain financially viable, they'll invest in the health of the planet.

Social

Companies that have a positive social impact resonate with large groups of people. People prioritize these causes differently, but they all seek to fulfill one cause: improved quality of life. These can be small triumphs or big-picture items. Here are some examples of what companies can do to be at the forefront of social causes:

  • Promote diversity and inclusion in hiring and promotion
  • Exhibit high employee morale and low staff turnover
  • Use ethical supply chains, such as fair-trade foods
  • Be an engaged member of its local community
  • Show appreciation of its employees in terms of pay and benefits
  • Take a public stance for justice on equality and human rights

You can often find companies that fit these criteria on lists like Fortune's 100 Best Companies to Work For. Pay attention to the news and look at their company's website and social media. Chances are, if they're championing social causes, they'll be promoting it.

Governance

Corporate governance is a huge indicator of the direction of a company. How a company runs itself at the top speaks volumes to its integrity. Here are examples of what to look for:

  • Transparency in communication with shareholders
  • Easy access to proxy documentation, meetings and voting
  • No exorbitant severance packages for executives
  • No board members with conflicts of interest
  • Ties compensation to long-term value, not flash-in-the-pan gains
  • Executive pay compared to pay of average worker
  • A healthy relationship with the SEC, EPA and other governing agencies

Unfortunately, when you hear about corporate governance in the media, it's often in the negative. You're hearing about Company A being fined by the U.S. Securities and Exchange Commission (SEC). Or you're hearing that average CEO compensation is over 200 times that of the average worker's. To really understand how companies are governed, look at their reports. If you can't find them, that could be a clue that the company is not very transparent.

ESG Strategies For Your Investments

Strategy plays a big role in any portfolio. Assessing risk and diversifying your investments is valuable, whether or not you integrate ESG criteria. There are a few major tools to consider when planning for ESG integration.

First, research companies' ESG ratings. Morgan Stanley Capital International (MSCI) is the largest provider of ESG indexes globally. They regularly rate companies for ESG performance. These ESG ratings range from field leaders at "AAA" to laggards at "CCC."

Next, research funds that specialize in ESG investing. Institutional investors – like mutual funds and hedge funds – are incorporating ESG at a growing rate. In fact, the 2018 ESG Institutional Investor Survey reports that "most institutions (80%) have an ESG component as part of their investment strategies."

ESG Exchange Traded Funds (ETFs) can also help diversify your portfolio. ETF.com provides a helpful list of the best- and worst-rated ETFs according to the MSCI.

Unless you're an expert, you could also benefit from speaking with an asset manager. Depending on your situation, an asset manager could be crucial to making smart investments on your behalf. Research asset management firms that practice ESG. If you're unsure of what you're doing, don't go into investing alone.

ESG Imposters

ESG investing comes with risk, just like any other investment strategy. In recent years, the spiking popularity of ESG has resulted in ESG investing being used for marketing purposes. ESG investing is still evolving, so expect improvements to help weed out imposters whose marketing campaigns mask a failure to meaningfully embody ESG principles.

Another risk to consider is that many ESG securities do not have a significant performance history. Many ESG funds are less than 10 years old and don’t have the years behind them like other funds do. They may not be able to report a decade of steady growth.

ESG Returns

Everyone wants to receive good returns on their investments. There's a lot of conflicting information over how ESG returns compare to conventional returns. The truth is that it depends on the investment and market volatility. Traditionally, non-ESG funds have a longer history of growth and may outperform ESG funds when it comes to returns.

If we look at companies that focus on ESG criteria, they often outperform companies with low ESG ratings. Consider JUST Capital’s 2021 Rankings of America’s Most JUST Companies. They ranked companies on five issues: employee treatment, customer treatment, community support, environmental impact and value to shareholders. Some of the companies that ranked the highest on these issues were Apple, Salesforce, Adobe, Intel and Microsoft – each named one of the best stocks to buy in 2021 by several different financial media outlets.

If you want further evidence of ESG stocks being financially viable, look at the 2014 study published by Harvard University. This study sampled 180 companies over 13 years and found that those who adopt sustainable practices "significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance."

Another example is to look at the performance of ESG funds during a national crisis. S&P Global's reporting during COVID-19 points to the fact that several ESG funds outperformed the S&P 500. 

Does ESG Investing Make A Difference?

Have you ever heard the phrase "vote with your dollar"? This applies to ESG investing. Publicly traded companies are in the position to enact change in the United States. By investing in companies that align with your personal values, you're promoting these values.

Rethinking Corporate Governance

But does it work? Consider this. In 1970, American economist Milton Friedman promoted shareholder value theory, sometimes referred to as agency theory, which posited that corporations should be run for one purpose only: to increase shareholder value. This thinking dominated conventional investor thinking for decades.

Today, there is much debate as to what shareholder interests should be considered more heavily – the interest in making more money or the interest in things like corporate strategy. According to a Harvard Business Review article this is causing CEOs and board members to rethink the role and purpose of the corporation beyond short-term returns to shareholders. One notable change, as the article states, was in 2019 when 181 CEOs signed a statement declaring their commitment to all stakeholders, not just shareholders. Leaders are also starting to experiment with ways to measure corporate performance, strengthen their risk oversight and find more ways to be transparent in reporting both financial and non-financial matters.

Companies Ignore ESG At Their Own Risk

Conversely, when companies ignore ESG factors, it negatively affects their balance sheet. Take, for instance, VW's stock plunge after its emissions scandal in 2015. Volkswagen was caught lying about the environmental impact of its vehicles, and paid dearly for it. Public opinion is a huge factor in a company's value.

At the 2020 WM Sustainability Forum, Marc Benioff, the co-founder, CEO and chairman of salesforce.com, laid it out succinctly: "When you buy a company, you not only get their intellectual property, you get their culture." This applies whether you're buying shares or buying the whole company. As more people place value in a company's approach to ESG issues, the more companies will address them. And as companies address them, the more difference the company will make on the planet and society.

Is ESG Investing Right For You?

Before investing, take stock of your finances. Do you have significant credit card debt? Do you have an emergency fund? Make sure you have your finances in order before thinking about entering the stock market.

With growing economic volatility due environmental and social issues, ESG investing may help you proof your portfolio. Do your due diligence and research companies and funds before putting your money into them. Consult with a professional like a financial advisor or money manager.

If you're investing for long-term, sustainable growth, ESG investing could be a good option for you.

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Lauren Nowacki

Lauren Nowacki is a staff writer specializing in personal finance, homeownership and the mortgage industry. She has a B.A. in Communications and has worked as a writer and editor for various publications in Philadelphia, Chicago and Metro Detroit.