Not very long ago, socially responsible investing lay on the fringe of the investment community. But today, virtually every corporation has a focus on sustainability. Matters of social justice, gender equality, executive compensation and shareholder rights are now considered table stakes for publicly traded companies. And the reason for this focus is that investors are demanding it.
A company’s environmental, social, and governance (ESG) score is a key component used by some investors and fund managers to determine the kind of company they will invest in. ESG investing is a much more nuanced view of investing than simply avoiding the “sin stocks.” In fact, many of the vice stocks are popular among ESG investors because they score high in other areas, and societal norms have changed.
But the only reason that ESG investing is growing is because over time investors are discovering that their investments in companies with high ESG scores are performing equal or better to high-growth companies with lower ESG scores over time.
Socially conscious investors want their capital to go to companies that support their values. Today this goes beyond the idea of avoiding tobacco and alcohol stocks to a more nuanced, data-driven approach called environmental, social and governance (ESG) investing.
ESG criteria measure a company on a set of standards in three areas: environmental impact, social issues, and corporate governance. Each of these areas is scored and the composite makes up a company’s ESG score.
In this article, we’ll define what ESG investing is and what it is not. We’ll also explain why these stocks offer less volatility but may actually be a better investment over time.
What Is ESG Investing?
Environmental, Social and Governance (ESG) investing integrates factors about a company’s actions towards environmental issues, social justice, and corporate governance, and makes them a fundamental part of the investment process.
The investment thesis behind ESG investing is that companies that have high ESG standards are more likely to outperform their peers over time. The support for this thesis lies in how the investments are chosen. The idea is that ESG is a filter that is applied to investments that are already perceived as offering strong fundamentals. From there, individual stocks or funds can be selected based on their ability to generate a scalable, profitable impact.
Environmental criteria measure how well a company performs on issues related to climate change such as its carbon footprint, how it reduces its greenhouse gas emissions, whether the company uses sustainable products and whether it efficiently uses natural resources including its commitment to recycling.
Social criteria looks at issues like a company’s commitment to community development. This may take the form of questions like does the company provide affordable housing or fair lending? Where does the company stand on issues of diversity and inclusion in its hiring practices? This is an area that focuses on human rights not only in the company’s home country but in all of the countries that it does business.
Governance criteria evaluates the company’s executive leadership and board of directors. This includes issues such as the level and reasonability of executive pay, the diversity of the board of directors and how responsive the board is to its shareholders.
What is the appeal of ESG investing?
At its core, the appeal of ESG investing is for investors to prioritize a belief that their assets can promote global issues such as climate change and social justice. This is particularly true of millennial investors who demonstrate by their buying patterns that they are more likely to trust a company and purchase its products if they believe it is being socially and/or environmentally responsible.
What ESG Investing is Not…Necessarily
ESG investing is sometimes incorrectly lumped in with two kinds of ethically-minded investing strategies. It can be most commonly associated with Socially Responsible Investing (SRI). This is a method of investing that essentially looks to screen out the “sin stocks” or “vice stocks.” A list like this might include companies that sell firearms, tobacco, cannabis, or alcohol products. It may also include stocks involved with sports gaming, casinos and the like.
Investors who practice this form of investing take the approach that investment capital should be used for morally “good” industries. While every investor has to decide for themselves what kind of companies they are comfortable supporting, narrowing stocks down in this fashion can limit the growth of a portfolio. Complicating the matter even further is that some sin stocks may have a high ESG score
The second kind of investing strategy that can be confused with ESG investing is impact investing. This is a more technical form of sustainable investing that seeks a measurable environmental and social impact alongside financial profitability. The problem is that these two ideas are not mutually exclusive and may be incompatible.
There is increasing evidence that individual stocks and funds focused on ESG investing do outperform the broader market at different times. This is lending more credence to this form of investing as a mainstream approach.
However, one reason for that may be that more companies make an effort to have a high ESG score even if they are companies that may not have been considered “social investing” stocks.
Less Reward But Less Risk
Historically, ESG investing is associated with a lower chance for outsized gains. This has to do with the beta of each stock. A stock’s beta is a measurement of how it correlates to a particular standard. For U.S. stocks that is usually the S&P 500.
The beta of the S&P 500 is 1. That simply means if you divided the price of the S&P 500 by itself, you would get 1. It’s that simple. Stocks with a beta at or near 1 (on either side) have a close correlation to the S&P 500. That means if the S&P 500 is up, that particular stock is most likely also up and with similar price movement.
If a stock has a beta of higher than one it means that if the stock is likely to be more reactive to price movements in the broader market. So if the index is up, high beta stocks may post a la larger gain. Of course, the opposite is true as well.
If a stock has a beta of less than one it means the stock is less reactive to price movements in the broader market. So if the index is up, a low beta stock may be up less. Conversely, if the market is down these stocks may have a smaller decline.
As it relates to ESG investing, stocks with a higher ESG score tend to have a beta closer to 1. For whatever reason, stocks with a lower ESG score tend to have a beta of more than 1.
However, investors who engage in an ESG strategy usually accept the reality that their investments may not outperform the broader market at a given point of time. And, they have shown a willingness to pay higher fees to fund managers who actively manage an ESG mutual fund or exchange-traded fund (ETF).
How to Create an ESG Portfolio
As you might expect, creating an ESG-style portfolio is no different than creating any other type of portfolio. The first question you need to ask is whether you want to find your own investments or if you want an advisor to do the work for you.
Identifying stocks can be very rewarding, but it is very time-consuming. An investment advisor can identify investments that meet your risk tolerance and goals. Today, there are digital advisors that can perform the same service for significantly less cost. If you are going to use an advisor (digital or otherwise) make sure that you understand their ESG methodology to ensure it is consistent with your beliefs.
Your next decision is to decide whether to choose individual stocks or to invest in mutual funds or ETFs. Individual stocks. As of 2019, there were over 300 open-end and ETFs that focused on ESG investing. And like other fund families, investors can choose funds that focus on a specific aspect of ESG investing, for example, green energy. This can help investors fine-tune the focus of their portfolio to address the social causes that mean the most to them. A note of caution should be applied here. When investors limit the number of companies that are eligible for them to invest in, they can limit their profit potential relative to broadening their criteria.
The last word on ESG investing
There is much chatter about the new type of retail investor. As these investors begin to make their mark on investing, it’s becoming clear that they are making their own rules. One of those rules is to find companies that are committed to having a positive impact on the environment, on social issues such as equity and equality and on how the company’s management is compensated and governs.
These will be the investors of the future so it’s not surprising that many companies are making sure that they have an attractive ESG score. And the good news is that there is increasing evidence that an ESG-oriented portfolio can perform as well, and in some cases, better than the broader market.
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