INVESTING • READ TIME: 5 MIN
"Behind every stock is a company. Find out what it's doing."
Peter Lynch
Over the past few years a number of investing trends emerged that garnered significant investor attention and media coverage: thematic mutual funds and ETFs, inflation protection (TIPS and I-Bonds, for example), cryptocurrency, Web 3.0 (the metaverse, artificial intelligence), and SPACs and direct listing as alternatives to traditional IPOs, for example.
Perhaps none of these trends have attracted more attention, captured more dollars, or polarized pundits as much as the practice of ESG investing. In short, ESG, which stands for “Environmental, Social, and Governance,” investing is the application of a set of standards on the universe of investable securities to filter out certain investments in an effort to align a portfolio with an investor's (ESG) values.
What is ESG?
Above all else, ESG investing is an attempt to allow investors to “put their money where their values are.” Broadly, investors seek to limit investments to companies who are “environmentally-friendly,” are good corporate citizens, and who are managed by responsible directors and officers.
Due to the metrics used in computing ESG scores or determining which types of companies will be allowed into ESG mutual funds or ETFs, this type of investing is also sometimes called socially responsible investing (SRI), impact investing, or sustainable investing. This “socially-conscious” form of investing has not only attracted attention, but it has also captured significant investment - Bloomberg estimates that investments in ESG funds could be as much as $53 trillion (globally) by 2025.
Source: GSIA, Bloomberg Intelligence
Breaking Down the E, S, and G
Environmental: Preserving and Improving the Natural World
Of the three categories in ESG, the environmental aspect is likely the “most familiar” and prominent. Common measures in this category include (corporate) energy use, climate policies, waste production and reduction, pollution/emissions, etc.
Companies may score higher in this category if they (actively) contribute to environmental conservation or have corporate policies in place to minimize their environmental impact, decrease energy use or pollution, etc. Broadly, environmental concerns may be broken down into emissions (pollutants produced, etc.), energy or resource use, and innovation (developing technology or processes to become more “green.”)
Social: Interdependency of Internal and External Participants
ESG’s “social” category evaluates a company’s relationship with both internal and external stakeholders - meaning, the way in which corporations interact with employees and the communities in which they operate
Akin to the style of investing known as “socially responsible investing” (SRI), the social element of ESG examines workplace conditions, and social themes such as diversity, social justice, corporate ethics. Additionally, items such as customer satisfaction, data protection and privacy, wage equality, and training and workforce development are taken into account.
Governance: Processes for (Effectively) Running a Business
Governance incorporates a company’s accounting practices, ownership and control, board independence, and ethics. Ultimately, governance identifies and quantifies factors related to corporate decision-making and policy-making - what roles and “rights” are given to different echelons of participants including directors, managers, shareholders, and stakeholders.
As is the case with the other elements involved in ESG, but perhaps more pronounced in the governance category, corporations and investors may view low scores as identifiers of potential risks - namely, regulatory, legal, and default risk. Conversely, positive scores and reports on corporate governance may equate to better operational efficiency and financial/operating performance.
How is ESG Measured?
As the demand for ESG-minded portfolios and investments has increased, so has the complexity (and confusion) surrounding ESG scores and the underlying scorecards used in the calculations. While many companies offer a “definitive” approach to calculating an ESG score, there is no absolute standard. Meaning, ESG data and scores can be a largely subjective exercise.
While it is understood that various environmental, social, and governance-related factors need to be quantified, assessed, and scored, there is a high degree of variance in the methodologies, categories, and weights applied to these metrics (by those who calculate a company or fund’s score.) This has been a fundamental critique of the ESG investing movement as it has risen to prominence.
Differing methodologies may also make it challenging for corporations to understand their own score - which, in turn, may cause confusion regarding ways in which to improve. However, upon standardization of scores and criteria, ESG may have a more permanent (and less "trend-like") place in investors' or institutions' portfolios. Ultimately, ESG investing may be a way to manage ESG risks, promote impact investing, and encourage corporate governance to create more sustainable business models and practices.
Potential Pros & Cons of ESG Investing
In addition to its social value, ESG investing may also help investors mitigate the drawdowns that occur when companies operating in a "risky" or unethical manner are held accountable (socially, financially) for the consequences. Events such as oil spills, attention or regulation regarding labor practices and standards, etc. may (and have in the past) influence stock prices, credit ratings, etc.
As ESG-minded practices gain more traction, investment companies (and investors) are increasingly tracking their performance. Financial institutions and analysts commonly publish annual reports that review their ESG strategies, approaches, etc. and overal results.
The ultimate value of ESG investing may hinge on whether this encourages corporations to change for “the common good,” or to simply perform better on an analyst’s scorecard. The prominence of ESG, particularly in the last few years, has led to critiques of companies misleading investors due to inflated ESG scores and/orbeing insincere in their actions.
Another possible downside is related to the “narrowed” realm of potential investments. By eliminating particular types of companies - tobacco companies, for example - investors may diminish their returns, dividends, or yield in exchange for a cause/ideology-driven portfolio.
As data availability, technology, and risk management techniques have improved, it has become increasingly possible for investors to utilize ESG factors to better align their portfolios with their values, while being mindful of issues relating to concentration, tracking error, and risk.
A Few Final Thoughts
Before integrating ESG into a portfolio, as is the case with any investment strategy, careful attention should be given to risk parameters. Meaning, careful portfolio construction is still necessary - even within the “universe of investable ESG securities.” Using ESG metrics to align a portfolio with an investor’s values may have unintentional consequences in terms of tilting toward particular industries or prioritizing one style of investing.
Investors are now increasingly eager to align their portfolios with ESG-related companies, fund providers, and investment managers. Based on current and possible future legislation, it may also be an area of significant growth in the broader market/economy. Ultimately, whether or not ESG investing is right for an investor's portfolio hinges on the desire to integrate personal values into investments, as well as return and risk expectations.
The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.