Everything You Need to Know About ESG Investing
Dear Rich Lifer,
Environmental, social and governance investing, known as ESG, is a form of sustainable investing that considers an investment’s financial returns and overall impact.
ESG investing allows you to use your money to engage with companies that are actively working to make the world a better place. This type of investing relies on independent ratings that assess a company’s behavior and policies as they relate to environmental performance, social impact and governance issues.
Hank Smith, Head of Investment Strategy at The Haverford Trust Company, comments, “At its core, ESG investing is about influencing positive changes in society by being a better investor.”
ESG investing is already becoming the biggest new trend on Wall Street and is only continuing to grow. According to the US SIF Foundation’s 2020 trends report, U.S. assets under management using ESG strategies grew to $17.1 trillion at the beginning of 2020. That’s a 42% increase from $12 trillion at the beginning of 2018.
Additionally, research shows that ESG investing can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks that they own.
So today, we will walk you through the basics of ESG Investing and tell you everything you need to know about building an ethical and profitable portfolio.
A Brief History of ESG
The term ESG investing was not created until the 2000s, but the concept is far from new. It began with religious groups such as Quakers and Muslims who avoided business dealing with tobacco or alcohol and wanted their portfolios to reflect this.
ESG investing was then adopted by other groups who wanted to align their investment practices with their beliefs. We saw this happen in the 1960s and 1970s with the anti-war movement, in the ‘80s regarding corporate accountability, and in the ‘90s with climate change initiatives.
These views rose up in direct conflict with shareholder value theory, which was popularized in 1970 by Milton Friedman and basically stated that companies’ only responsibility is to maximize shareholder value — aka make the most money.
Modern investors are increasingly realizing that shortchanging stakeholders to increase shareholder returns is taking an incredible toll on society and needs to be changed.
Enter ESG investing…
As we mentioned above, ESG investing is investing in companies that score highly based on three categories of criteria: environment, social and governance.
Let’s explore the three factors, what they entail, and an example of a company that can be used as a model in each category:
Environmental: These factors include how a company mitigates its greenhouse gas emissions, whether the products the company creates are sustainable, if it uses natural resources efficiently, how it handles recycling, the size of its carbon footprint, environmental benefits for employees, and many other aspects.
For details about concrete environmental data, you will need to locate sustainability reports, which should be prepared using respected sustainability standards, such as those established by the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI).
Nike (NKE) is a great example of what investors should look for in an environmentally conscious company. It has a recent sustainability report that applies the GRI framework, the Sustainability Accounting Standards Board (SASB) principles, and the United Nations’ Sustainable Development Goals (SDGs).
Social: This component includes factors both inside and outside the company and consists of people-related elements like company culture and issues that impact employees, customers, consumers, suppliers, the local community, and society at large.
Social aspects include diversity and inclusion, employee treatment, ethical supply chain sourcing, customer service, and a public stance on social justice — among other issues.
For information on a corporation’s social performance, check out sustainability reports that use the GRI or PRI framework, which go beyond environmental issues to include information pertinent to employees, suppliers, and the community.
You can also keep up with respectable rankings like Fortune’s Best Companies to Work for or read reviews on websites like Glassdoor, which allows employees to review their company.
Accenture (ACN) is a standout example of a well-regarded workplace and has earned a spot for 12 years on Fortune’s list of Best Companies to Work For. Accenture’s Corporate Citizenship Report shows efforts to satisfy some of the UN’s SDGs and also uses the GRI disclosure standard.
Governance: This refers to how the company’s leadership board and management drive positive change. It includes issues related to executive pay, diversity in leadership and how well that leadership interacts with shareholders.
Corporate governance is brought to light every year during proxy season, when most companies file their proxy statements, which announce annual meetings, define the issues to be voted on, and provide relevant supporting information.
Reading both sustainability reports and proxy reports (which are on the SEC’s website) should give you a very clear idea of how well a company is performing in terms of corporate governance.
Intuit (INTU) is a perfect example of strong corporate governance. It has a 40% diverse board and extensively documents its board structure, strategy, and compensation, along with the board’s audit, risk, and oversight processes.
Why Should You Consider ESG Investing?
There are multiple benefits to ESG investing, including high returns and low risk.
A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds. The paper revealed that from 2004 to 2018, the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds.
The same study found that sustainable funds repeatedly showed a lower downside risk than traditional funds, regardless of the asset class. It showed that during turbulent economic years (like 2008 and 2009), sustainable funds experienced a 20% smaller downside deviation than traditional funds. In other words, traditional funds had a higher potential for loss.
JUST Capital ranks companies according to factors like whether they pay fair wages or take steps to protect the environment. It created the JUST U.S. Large Cap Diversified Index (JULCD), which includes the top 50% of companies in the Russell 1000 (a large-cap stock index) based on those rankings.
Since its creation, the index has returned 15.94% on an annualized basis compared with the Russell 1000’s 14.76% return.
Smith of The Haverford Trust Company remarks, “There’s a misconception out there that you need to be willing to give up returns in order to invest responsibly but a growing body of research shows that ESG actually helps mitigate risk.”
We will likely be diving deeper into ESG investing in the coming week so stay tuned as we discuss how to find ESG funds and start investing.
To a Richer Life,
The Rich Life Roadmap Team