If you typically read the list of ingredients on the back of food packages, you already know how to approach ESG investing.
“ESG” stands for three factors fundamental to corporate accountability and sustainable performance: environmental, social and governance. There’s a whole industry that tracks and analyzes how well companies do on ESG factors, with the aim of informing investors who might want to buy assets that align with their personal values.
But analysts and advisors said that putting your money where your values are is more complicated than buying into funds and stocks that wear the ESG label. You’ll have to learn about the factors that resulted in those ESG scores and then figure out how those investments support your financial goals.
What are the E, S and G in “ESG”?
Many companies make sweeping statements about their commitments to environmental concerns, social issues and corporate governance. But ESG investors should always scrutinize their annual and ESG reports for specific evidence of each year’s ESG advance and their overall progress toward their own ESG goals. These reports are found in the “investor relations” sections of the websites of publicly held companies.
Environmental
Environmental impact and responsibility encompass everything from how a company manages the direct effect of its operations on surrounding neighborhoods, land, air and water to how it manages its contributions to big-picture environmental dynamics, such as carbon emissions. Environmental responsibility usually includes the company’s track record with legally required standards: A company that considers fines for violating environmental laws as simply a cost of doing business may not be a company that is proactive about anticipating the financial and operational risks that accompany its operations.
Social
Social issues include racial and economic justice, both internally and as corporate citizens. Employee well-being and safety can be measured and improved. How engaged is the company in helping to solve problems in the communities where it is located, and how does it contribute to progress on national issues, such as universal access to quality K-12 education?
Governance
Governance is the fancy term for the mature, thoughtful use of company resources to achieve sustainable results for everyone involved: shareholders, investors, employees, suppliers, vendors and communities. Running an orderly organization that doesn’t get into legal scrapes is a good start. Making the most of talent by ensuring that all employees can grow and contribute their best is a proven way, according to Credit Suisse, which measures the difference in corporate performance delivered by diverse management teams.
How does ESG investing work?
ESG investing is more about data than politics or personal values, explained Susie Wang, director of the investment strategy team with wealth management firm Balentine.
“ESG is one way to assess how companies manage risks and opportunities. It’s not your personal values as much as it’s about data that analysts use to measure companies’ ability to manage anticipated future changes,” she said. Just as any one food may or may not be a good pick depending on your dietary and health goals, any one highly-rated ESG stock or fund might or might not support your investment horizon and the financial return you need to achieve those goals, Wang explained.
“You have to think holistically. If you like a company, do your homework, and understand what are the specific impacts that this company is making. Then you can think about this investment, as one of the many in your portfolio,” she said. “Think about the actions that you’d like to support — and realize that every company and fund will present a mixed picture.”
For example, some companies centered around fossil fuels are also major investors in green energy. A strict ESG lens focused on environmental factors might exclude them based on current operations, but a view that prioritizes sustainable energy might include them because they also are building energy sources for the long run.
ESG investing versus socially responsible investing (SRI) versus impact investing
ESG factors are generally considered to apply to companies’ current operations, explained Tracy Barba, director of venture and equity ethics at the Markkula Center for Applied Ethics at Santa Clara University.
The “socially responsible” investment philosophy is more sweeping and aims to encourage companies to think about big-picture impacts of aggregate decisions. “Impact investing,” said Barba, “drives change and doesn’t just reward change. You’re thinking through the potential outcomes of the investment.”
| Strategy | Focus |
|---|---|
ESG investing | Examines how ESG factors pose risks and create opportunities for companies in order to maximize returns |
Socially responsible investing | Promotes investing based on one’s ethics and values rather than focusing on returns |
Impact investing | Focuses on making investments to advance social and environmental causes while still generating positive returns |
Steps to start ESG investing
It’s a big universe, so start with what’s already in your portfolio, advised Michael Young, director of education and outreach for US SIF, the Sustainable Investment Forum. The forum works with companies to focus on sustainable, long-term investments that integrate “positive social and environmental impacts.”
Wade into ESG by first collecting the stock or fund symbols for the holdings in your retirement accounts and investment portfolios. Then, recommended Young, run those symbols through the Invest Your Values assessment tool at As You Sow, a nonprofit that provides consumer-friendly snapshots of ESG rankings and data.
The As You Sow tool helps you “figure out what you have,” said Young. “You’ll know if a fund has a certain amount in private prisons, say, or weapons of war, gender equity, deforestation, you name it.”
Once you can view the ESG factors in your portfolio, you can line them up with your own priorities. Bearing in mind that ESG investing involves a lot of trade-offs, you can identify investments that both achieve your financial goals and that at least somewhat reflect your personal priorities.
How are ESG scores calculated?
“These ratings are most useful for professional investors, who use the data to build investment models,” said Young. If you want to put a fund under the ESG microscope, use tools at Morningstar, a fund analysis firm, to see how its analysts weight different factors to arrive at various ESG scores.
While the calculations that go into figuring ESG scores are quite involved and vary by provider, Morningstar uses a two-step process to determine a fund’s Sustainability Rating. First, it calculates a “Portfolio Sustainability Score” that measures how companies within the fund are managing ESG risks and opportunities. It then measures that score relative to a fund’s category peers to determine its Morningstar Sustainability Rating.
But, said Barba, remember that “ratings systems are based on self-disclosed information and what’s been deemed to be financially material.” Company disclosures may not tell the whole story and, thus, ratings may be based on incomplete data.
Choosing your ESG investments
Advisors and analysts stressed that nearly every company and fund represents a mixed ESG bag. Technology companies, for instance, might offer strong, consistent financial growth; appear to make sound environmental choices; and invest in products that might improve human well-being — all with a disproportionate number of white, male engineers and leaders, largely cutting minorities and women out of career and economic growth opportunities.
One way to consider ESG factors is to look at small, measurable steps that companies take on values that are important to you. Through annual reports — financial, ESG and diversity — available at the websites of publicly held companies, you can see specific steps that companies take and then decide if those steps merit the company a place in your portfolio.
Pros and cons of ESG investing
Exploring ESG factors is a good entrée to investing strategies overall, advisors and analysts say, especially as you trace the effect of ESG-linked decisions with financial results, and vice versa.
But investors sometimes err by taking a hard line about some industries that could also make their portfolios vulnerable, said Wang. When scorned industries do well, they don’t lift the results for a portfolio that doesn’t include them. That’s especially important for major categories, like consumer goods and energy, Wang said, that are embedded in many financial performance indices and sectors.
“If you accept that, then you have to realign the financial return you will get and how that supports your financial horizon and goals,” she said.
ESG performance over time
That said, data from credit ratings agency and index provider Standard & Poor’s (S&P) show its ESG index outpacing the S&P 500 in recent years. The S&P 500 ESG Index’s annualized return is ahead of the S&P 500 over one-, three-, five- and 10-year periods.
Outperformance like that can make a big difference in returns over time, but it’s important to note that the S&P 500 ESG Index only launched in January 2019. Data before its launch date is back-tested in the following table.
| Index | One-year | Three-year | Five-year | 10-year |
|---|---|---|---|---|
S&P 500 | 27.9% | 9.8% | 13.1% | 10.9% |
S&P 500 ESG | 28.5% | 11.2% | 14.6% | 11.5% |
S&P Global data as of March 28, 2024
Frequently asked questions (FAQs)
ESG factors are another way of thinking about long-term decision-making, said Wang and Young. ESG purports to assess how well a company supports and responds to environmental health and regulations; how it advances socially disadvantaged people, whether that’s through diverse employees or the communities in which it operates; and how transparent and accountable its governing board and executives are to investors and the public. These dynamics are all fundamental to corporate operating decisions, risk management, strategy and growth plans. ESG factors add dimension to financial results and so provide a more complete picture of a company’s goals and how it will achieve them.
ESG factors that are captured by current rankings and analysis can, by definition, only measure what currently exists. Impact investing seeks to invest in emerging sectors and ideas that might not yet be big enough to show up in ESG models. Impact investing targets a specific factor that seeks to affect the growth or retreat of that factor. For instance, a company might deliberately hire minority-owned companies as contractors, thus fulfilling an investor’s impact investing goal of supporting underrepresented entrepreneurs. In general, socially responsible investing takes a broader and longer view, urging companies to consider the wide-ranging future effects of today’s decisions.
Advisors stress that investors can best use ESG insights, reports and trends to guide their overall understanding of how funds and companies anticipate and respond to broad trends. An ESG perspective helps you understand how industries and companies blend environmental, social and accountability (i.e., governance) dynamics with their financial and growth goals.
Some funds specifically label themselves as “ESG,” so they offer a good starting point for do-it-yourself analysis, analysts and advisors say. Funds must disclose what they hold, so examining what stocks an ESG-labeled fund holds, and how much of each stock, can yield insight into how fund managers apply ESG principles to portfolio design.
