Understanding ESG investing

A beginner’s guide to ESG investing

Growing awareness about the need to make a positive societal impact – and the economic benefits of doing so – is starting to make itself felt in the world of investment.

There have been persistent calls from international bodies such as the United Nations for corporates to “do the right thing”, as well as a growing push from individual investors who want to know that their money is being invested in an ethical way. These factors have influenced large investment companies to take Environmental, Social and Governance (ESG) factors into account when making decisions about where money should be invested.

And although ESG investing has a strong ethical element, it’s not all about “doing the right thing”. While ESG investing might initially have been driven by moral concerns, it is increasingly being linked to superior performance. The argument is that companies that make good ESG choices become well-run companies, and that well-run companies become good investment choices. For example, a 2019 McKinsey study found that companies in the top quartile for diversity in gender or ethnicity on executive teams were 25 percent more likely to have above-average profitability than companies that had less diverse representation.

Because of these factors, ESG investing has moved from the fringes of the investment world to the mainstream over the last decade, with an ever-growing inflow of money into ESG funds.

How ESG works

When deciding what companies to invest in, asset managers have always used a variety of criteria to determine profitability and future returns. These would include traditional factors such as cash flow, market position and industry trends.

ESG investing uses ESG factors (which are non-financial factors), such as a company’s practices and policies, in the analysis process when weighing up profitability and future returns. Investments would be made in companies that score high on ESG ranking scales.

These rankings are created by independent third-party companies and research groups, which would look at non-financial factors such as sustainability measures, annual reports, resource and financial management, and board structure. They would then create scores for companies, based on multiple criteria, that enable investors to compare different investment opportunities.

The bottom line with ESG investing is that the primary consideration remains financial performance – it is not intended to be implemented at the expense of returns. This is different to other sustainable investment styles, such as impact investing (which aims to maximise societal reach).

Let’s take a closer look at the three criteria making up ESG:

Environmental

This focuses on the impact a company has on the environment. Specific elements of this would include pollution, approach to waste, the treatment of animals and compliance with environmental regulations.

Social

This covers a company’s social impact, both internally and externally. For example, how a company might deal with employee health and safety or encourage racial diversity within its staff, or it’s social impact in the wider world, such as whether it donates to local communities.

Governance

Governance would look at the behaviour of a company’s board and management. For example, leadership choices, renumeration for executives, transparency in accounting methods, conflicts of interest etc.

Investing with an ESG focus

There are various ways for individual investors to incorporate ESG strategies into a portfolio. One entails taking a company’s ESG profile into consideration when deciding whether or not to by shares. In other words, the investor targets individual stocks that follow ESG principles and align with his or her investment goals. But for many investors a simpler route is to opt for one of the growing number of ETFs focused on ESG strategies.

Advantages of ESG investing

The obvious advantage of ESG investing is that it gives investors confidence that their money is playing a role in creating a better world. Investing in ESG-orientated companies can potentially play a role in helping protect the environment, creating a positive social impact and encouraging ethically focused corporate behaviour.

Initial criticism of ESG investing was that it meant comprising returns. But various reports have shown that focusing on sustainability considerations can be in the best economic interests of companies – resulting in innovation, low employee turnover, operational efficiencies etc – and can help them develop competitive advantages. And so a focus on ESG can deliver value for both shareholders and the planet. It is also argued that ESG funds have shown resilience during periods of high market volatility.

Disadvantages of ESG investing

By opting to invest in line with ESG principles, it is argued that investors don’t have the entire investment spectrum available – potentially limiting diversification.

Some commentators have noted that many ESG indexes and index funds have shown strong performance in the past due in part to the large exposure to tech companies – and that this over-concentration on one sector can present a risk to investors.

Analysts also warn that although expense ratios for ESG funds have decreased over the years, they can still be higher than other funds – which means that you might be paying a slight premium to invest in these funds.