Investors are placing more emphasis on ethical and environmentally responsible performance.
Key Takeaways:
● ESG stands for Environmental, Social, and Governance. These criteria are used to evaluate companies beyond typical financial metrics.
● The United Nations “Who Cares Wins” report of 2006 popularized corporate self-reporting on ESG metrics.
● Many ESG-themed investment funds have exhibited strong long-term growth.
● ESG investments include mutual funds, exchange-traded funds (ETFs), and individual stocks.
In his 2007 bestseller, author and investor Phil Town explained why Rule #1 is investing in the companies you believe in, rather than those with the best recent stock performance.
A heightened public focus on sustainability, social equity, and transparent business practices has contributed to a dramatic increase in investments based on ESG metrics over the past several years. These metrics quantify the ethical and environmental values of an organization alongside their financial results.
In this blog post, we’ll explain the meaning and importance of ESG and describe how it is incorporated into today’s investment strategies.
What is ESG?
Companies use environmental, social, and governance (ESG) frameworks to report on important factors like carbon emissions, waste management, diversity, sustainable productivity, and ethical business practices that are not included in traditional financial reports. Since there is no standardized measurement or reporting format, there are many different ESG frameworks in existence, each with its own elements and metrics.
The underlying principles of ESG, including ecology, fair labor practices, and corporate transparency were already gaining momentum for decades when the United Nations organized these ideas into the Who Cares Wins report of 2006. The U.N. encouraged all business stakeholders to embrace ESG metrics going forward. Today, 99% of S&P 500 companies report on their ESG performance.
How does ESG differ from traditional investing?
Traditional investment practices focus primarily on expected financial risk and return based on historical and projected performance. ESG factors in additional metrics that speak directly to the culture and core values of the business. Companies that don’t meet predefined ESG standards are often excluded from selective ESG funds.
ESG criteria varies, with some frameworks giving increased weight to sustainability factors like carbon emissions and recycling while others are more equally balanced between environmental, social, and governance factors. An ESG score quantifies a company’s alignment with the specified criteria, typically using a 0-100 point rating scale.
How to invest using ESG criteria
There are over 140 firms in the United States alone qualified to calculate ESG scores, and each firm uses a slightly different approach. Some criteria apply to nearly every business, but measurables like resource conservation, diversity, and data security may not be relevant for small companies. Most ESG investing strategies include:
● Screening: Companies are selected (or excluded) based on the alignment of their sustainability and ethical principles with pre-determined requirements.
● Integration: ESG factors are integrated with traditional financial metrics to determine how a company’s ESG performance is likely to impact their profitability.
● Impact: Is the company making (or planning to make) a positive impact? This part of the analysis assigns additional value based on societal contributions.
ESG investment options
ESG investments are not limited to mutual funds. Many investors select individual stocks based on their ESG score and screening factors that align with their personal views. ESG-themed exchange-traded funds (ETFs) are available for those who wish to incorporate a broad range of ESG stocks into a single investment while maintaining the flexibility to buy or sell at any time.
Evaluating EGS fund metrics and key considerations can be challenging since traditional indicators like revenue and earnings only tell part of the story. Investment advisors are adept at helping individuals develop a portfolio that balances their risk tolerance, goals, and ESG priorities.
Successful ESG investing examples
Investing in ESG funds does not require a choice between a sustainable future and optimized returns. While results have varied from year to year, the S&P 500 ESG index has posted returns of 73.2% over the past five years, compared to 61.1% for the broader S&P 500.
Not surprisingly, enduring organizations like Adobe, Applied Materials, and Nvidia that couple high ESG scores with high annualized growth consistently rank among the top ESG companies to invest in.
Case study 1: Microsoft
Microsoft has emerged as a top ESG performer while continuing to sustain their growth and profitability, with exceptional ratings in all three (E, S, G) categories. Along with ambitious goals to achieve carbon neutrality by 2030, Microsoft has prioritized diversity and inclusion throughout the organization and supported a variety of important philanthropic initiatives.
Case study 2: DFA U.S. Sustainability fund
This top-rated ESG fund outperformed the overall S&P 500 index by 8.3% in 2022 and includes more than 1,000 small and mid-cap stocks. The DFA U.S. Sustainability fund excludes companies with high carbon emissions, but also places a premium on profitability and value.
Case study 3: iShares ESG Aware ETF (ESGU)
The iShares ESG Aware MSCI USA ETF is the largest and most established ESG fund in the ETF space. This ETF has about 300 holdings, many of which, including Apple and Microsoft, are commonly found in non-ESG large-cap funds. The ETF is limited to companies with high ESG scores, although the company’s end products need not be of the green variety.
ESG investing FAQs
What are the different types of ESG criteria?
The wide range of ESG criteria includes environmental (E) factors like energy efficiency and pollution, social factors (S) such as diversity and engagement, and governance (G) factors including board composition and executive salaries.
How do ESG scores differ from company to company?
A lack of standardized scoring models leads to variation between ESG scores, especially when companies from different industries are compared. Experts familiar with specific rating agency scoring methods and frameworks can compare these scores more equitably.
What are some potential drawbacks of ESG investing?
ESG may not be right for investors whose top priority is maximized returns, since the funds may exclude high performers and startups based on their poor ESG scores. The lack of standardization has also led to some backlash over the perceived unfairness of ESG rating and reporting systems.
How can I evaluate an ESG fund’s performance?
Each ESG fund must be evaluated based on financial metrics as well as ESG impact assessments. The most successful funds are those that continue to improve in both categories, signaling a positive, cyclical impact of ESG criteria on returns.
Is ESG investing only for socially responsible investors?
ESG is often associated with socially responsible investing that prioritizes companies actively working to resolve societal issues. However, ESG investing has also become a mainstream option for any investors seeking positive long-term financial performance and diversification.
References
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