- Ethical investing starts with ESGs: Environmental, Social, and Governance.
- There are ESG mutual funds and ETFs available, and ESG scores to help evaluate companies.
- Ultimately, you need to decide what kind of impact you want to make, and then invest your money.
Environmental, Social, and Governance (ESG) investing has made a lot of headlines recently, from the Wall Street Journal’s series, Why the Sustainable Investment Craze is Flawed to Morningstar’s rebuttal that sustainable investing is part of a long-term shift in the way people approach their investments. Many people are left to wonder how to think about ESG investing and how to get started.
According to Barron’s, US ESG mutual fund and ETF assets have soared to a record $400 billion in 2021, up 33% from the year before. Despite this strong growth, the overall market share is paltry, at just 1.4% of total US mutual fund and ETF assets.
With some conflicting viewpoints and huge market potential, it’s hard to know where to start. Here are three things to consider before getting started with ethical investing.
1. What are you prioritizing, and why?
There is no one true, universal definition of socially responsible investing. It’s up to you to determine and define. Start by asking yourself: What are my values? What do I truly care about? How do I express that through my actions? business guru simon sinek would call this determining your “Why.” You’ll need it to guide you through an ethical investing journey.
The ABCs of ethical investing are ESGs: Environmental, Social, and Governance. Environmental includes things like a company’s energy use, waste, and pollution; Social can be a company’s gender parity, diversity and inclusion efforts, and community investments; and Governance can include compliance, like ensuring companies are avoiding illegal practices, have transparent accounting practices, and offer shareholder interaction.
ESG is a big umbrella term and can mean different things to different people. There are an unlimited amount of issues in the world and many ways to address them — without any focus, it’s hard to have transparent reporting and results. Start with defining what problem you are trying to solve or the cause you’re fighting for.
2. Do your homework
Now that you have a specific focus in mind, it’s a lot easier to get to work. Spoiler alert: Not all ESG funds are created equal. If you don’t do your research or employ someone else on your behalf, make sure you are getting the impact you think you are.
Take ESG scores for example. These scores are calculated by investment firms that create their own scoring models to evaluate the ESG impact of a company. If this is your sole basis for comparison, it’s important to know that a company’s ESG rating is very subjective and there is often a lack of focus on what’s actually being measured.
What you may care about as an investor may not be fully captured in the scores. This is because there are dozens of underlying metrics for each of the ESG parts/scores. For example, in the Social category, or “S,” a score could reflect employee safety, labor relations, business ethics, etc. Not every factor is material for every company in the same way. A lot of these variables are not widely available, and if they are, they are not audited. The outputs, or the scores, are only as good as the inputs, or the “qualifiers.” So before comparing scoreboards, be certain to consider the source.
Even the ratings providers themselves can’t seem to agree with one another. Research Affiliates looked at the 20 largest
companies in the United States and showed instances where two providers can have rating differences greater than 25%. Facebook, or now Meta, had an E score of .77 by one provider and .23 by another. This significant difference is hard to decipher and understand by the average investor.
Ultimately, you want to be able to define the goal you’re after and how you’ll measure the outcome. The in-between can be thought of as the “How” in Sinek’s Why, How, What bulls eye. In other words, this is how you do your “Why.”
Not too long ago you likely had to sacrifice some return to invest in a values-based portfolio. Not so much anymore. While it’s important to note there currently isn’t a known or evidenced-based premium for investing in a sustainable manner, it also doesn’t need to cause underperformance. The evidence shows us we can get similar high-quality investments with returns similar to a non-ESG fund, provided we do it right and stick to sound investment principles like diversification, lost cost, low turnover, etc.
A few other honorable mentions — don’t get fixed on comparing your “traditional” investments to your “sustainable” investments’ performance by using the same indices as benchmarks. This is true if your sustainable strategy is intentionally “screening out” or minimizing a particular sector, like oil and gas. Relative to the market, it will inherently be different by design. Understand that traditional investment benchmarks may only be a rough approximation, and not a true apples-to-apples comparison.
Another easy criticism of ESG investing is the lack of diversification or exclusion of certain sectors within funds. Many economists would caution against this, with the argument that kicking out sectors or industries entirely is short-sighted. It takes the entire economy to run the world, and doing so decreases the diversity of the fund. Eventually, kicking out sectors could leave you with an overweight of large-cap technology companies. A best practice here may be to exclude or re-weight, but not concentrate.
3. What do you intend to do?
For my company, Uplevel Wealthour “what” is providing a great investment experience while addressing focused sustainability outcomes, specifically regarding climate change and reduction of greenhouse gas emissions.
What are you focused on? How are you measuring outcomes? Are there additional “returns” you are looking for, perhaps societal and personal?
Sustainability investing expert Sam Adams His societal attributes return to a simple preference for buying more organic food. In doing so, he hopes the demand for sustainable agriculture increases, driving overall better farming and practices.
Adams also notes the weather is changing, storms are becoming stronger, and we’re seeing more floods and wildfires. Are the companies we are invested in prepared for these changes? Are you interested in investing in companies that are paying attention to these things?
Long-term ESG investors have many reasons to be optimistic about the future. Seven out of the ten largest pension funds in the world invest in sustainable funds, which will continue to pressure big corporations to make positive changes. Additionally, the Securities and Exchange Commission just proposed new rule changes requiring companies to report their greenhouse gas emissions and details of how climate change is affecting their businesses. We’re confident markets will work better with more standardized information, and the new SEC disclosure should help drive better outcomes.
While it’s not always easy, the message remains consistent — much of investing requires taking the good with the bad. Remaining focused and disciplined, regardless of ESG strategy, is what leads towards future rewards in the long run.