ESG investing is a style of investing which considers the social and ethical goals of corporations along with their capacity to make a profit. Sustainable investing has never been more popular and is projected to reach one-third of all investment assets under management by 2025. But what is ESG investing and why is it growing at such a rapid rate? Here we look at the driving forces behind this upward trend and the pros and cons of an ethical investment strategy.
What is ESG investing?
In an increasingly socially conscious world, investors are beginning to consider more than just financial risks and opportunities when they invest. ESG stands for Environmental, Social, and Governance, with ESG investors considering factors such as climate change strategies, human rights, and business ethics when investing. ESG investors do so with the knowledge that pressure from investors is a big factor influencing corporations to employ responsible social, environmental, and governance policies.
ESG investment decisions can be made in myriad ways:
- Determining sectors to invest in (or avoid investing in, such as fossil fuels);
- “Integration”, by which investors consider the risks and opportunities ESG factors have on different companies;
- Basing investment decisions on specific structures (for example female leadership);
- Or investing based on a specific goal such as net-zero carbon emissions.
What are the main drivers of ESG?
Mitigation of investment risk
During economic downturns, ESG investments may actually provide downside protection. With considerable growth in sustainable products and greener energy sources, companies are evolving to meet these demands, meaning utilizing an ESG investment strategy can lead to investment in companies with longevity and continued growth. Companies that score high on ESG principles also tend to score highly on other metrics and have stronger financial performance.
ESG investments are relatively affordable right now
After the pandemic ESG investments were incredibly popular, driving up their prices. However, more recently the market has pulled back and ESG investments are becoming more affordable, potentially making them good value for long-term investors who want to spend their money in a socially conscious way.
Higher demand from investors
The trend of engaging in sustainable business practices and investments is here to stay, with environmental sustainability and an expectation of ethical practices pervading all areas of life. From the move away from fossil fuels to renewable energies to the development of artificial intelligence and younger generations’ desire to protect the environment for future generations, this all points to a growing long-term trend in ESG investing.
Public scrutiny is higher than ever
With so much access to information, and public scrutiny being at an all-time high, companies need to ensure their reputations are good and that in the court of public opinion, they’re coming out on top. This reputation feeds into where institutional investors direct their capital, and in turn, this influences where asset managers place funds. With ESG tools and metrics readily available to the public and investors, and new ESG indices available, it has never been easier to consider ESG when investing.
What are the risks of ESG?
Considering ESG is relatively new
Until recently, a big challenge for investors has been the lack of measurement around ESG, which can make decision-making hard. However, with an increase in metrics and tools to measure ESG, institutional investors are finding it easier to benchmark ESG performance.
The rapid adoption of ESG may be a bubble
ESG has taken off quickly. With such a large momentum behind ESG investing and the rate at which it’s continuing to build, it could be headed toward a bubble that may pop. In order to know whether or not ESG is headed for a dip, it’s important to be aware of ESG investing in context; are investors considering not just sustainable investing and socially responsible investment, but are they also aware of financial results? And what else is on the horizon that could continue to perpetuate ESG or cause its rapid rise to falter?
The disparity between interest and investment
Not all advisors are informing their clients about ESG investing, meaning that while there is a large amount of interest in ESG when investors aren’t informed, they may not become a part of the momentum by investing in the trend.
ESG investing may cost you more
ESG funds charge a higher expense ratio for companies that may be cheaper in other major indexes or funds, meaning investors may be charged a premium simply for investing in ESG. In an industry that has seen shrinking fees for years, the high demand for ESG offers a perfect marketing opportunity for fund managers to hike their fees up.
Your ESG investment may not live up to its promises
Some funds may own what they believe to be ESG companies as they are assessed by the same metrics as other ESG investments, however, they may not be in line with an ESG mandate. For example, tobacco companies will score well on sustainability metrics but don’t meet expectations in terms of social consciousness. Some funds may also invest in socially conscious companies from emerging markets, however, these companies may produce fossil fuels or contribute to other environmentally damaging activities.
How to start investing in ESG
Do your research
If you want to begin making ESG investments, have a look at exactly what ESG entails and the bounds in which it sits. Everyone has different values and beliefs, so if ESG is your primary driver for investing, ensure you know where the bounds of your ethics are and if they align with your investment.
Decide whether you want to invest by yourself or enlist help
If this is the first time you are investing, you can set up a brokerage account online. Some brokerages have tools that will help you find companies that are in line with ESG principles. You can also enlist the help of a Robo-advisor, which will build and manage your investment portfolio based on your personal goals and risk tolerance. Robo-advisors are usually more affordable than in-person advisors.
Decide on the composition of your portfolio
If you have your heart set on a specific company and believe it will be a good investment, you may wish to invest in its stock. You can do a deep dive into an individual stock by looking at reviews of the company’s work conditions, or by looking into its cultural and sustainable initiatives. Ideally, however, you will diversify your portfolio by also investing in funds or other asset classes, rather than limiting your portfolio to individual stocks. Funds can quickly bulk out your portfolio and with hundreds of diverse ESG funds available, you have the power to invest based on your specific areas of interest in ESG.
Begin investing, looking closely at your investments
Before following through with investments, ensure you are reading independent research firm reviews. These give you an overview of a company’s or fund’s scores and metrics around various ESG factors. Once you have a firm grasp on what you’re investing in, you can begin expanding your portfolio.
How is ESG calculated?
There is no one gold standard metric for ESG ratings. Data is pulled from a variety of places by a range of providers. Data may come from a company’s disclosures, from NGO, academic, or government databases, or even industry-specific questionnaires gathering data reported by the organization itself. This information is then converted into a range of ESG indicators such as climate change effect, greenhouse gas emissions, executive pay, board diversity and structure and employee relations and diversity.
How to track ESG investing
The key to tracking any investment is to be aware of how it’s performing and how market events are impacting its volatility. It’s also important to be guided by your own goals and strategies.
Using a trusted online portfolio tracker like Sharesight can provide invaluable insight into your investments. With the latest price and performance data for thousands of stocks, ETFs, and funds worldwide, along with an advanced suite of reporting tools, investors have all the information they need to make better investing decisions.
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