More and more investors are trying to use their investments to promote their values, a process known as ESG investing. For many, this means avoiding companies they perceive as harmful and seeking companies they believe will support a sustainable future.

ESG – Environmental, Social and Governance – is a general term used to align investments with personal values ​​and beliefs about environmental protection and social change. The term is interpreted in different ways by different investors and there has been much debate about whether ESG investing is financially profitable.

Let’s take a closer look at that.

How does ESG investing work?

ESG investors assess future investments on three main criteria.

Environment. Investors look at a company’s carbon footprint, renewable energy use, pollution record, use of eco-friendly suppliers, public stance on climate change, and similar factors. Social. ESG investors look for companies that pay fair wages and insist that their suppliers pay fair wages. They also look at hiring practices and diversity in the boardroom and workforce, and the company’s track record of including women, minorities and other disadvantaged groups. Management. Does the company’s management actively pursue sustainability? Is the remuneration of directors in line with that of employees? Does the company actively protect the interests of customers, employees and shareholders?

Evaluating these criteria is not always easy, especially at a time when ‘greenwashing’ – publishing a superficial sustainability effort while pursuing unsustainable practices behind the scenes – is common. Investors should carefully review and assess companies based on their own criteria.

👉 For example, if a fossil fuel company has an excellent track record of diversity and inclusion, pays its employees well and offers the best environmental practices for its industry, does it deserve inclusion in an ESG portfolio? Some may say yes, and some may say no. It is a decision investors must make based on their own priorities.

Approaches to ESG Investing

Investors typically choose two approaches to ESG investing.

Negative screening eliminates investments in sectors or companies that are considered incompatible with ESG criteria. Many ESG investors avoid sectors such as fossil fuels, weapons, alcohol, tobacco and others that they consider to be actively harmful. Positive screening involves looking for companies believed to make a positive contribution to sustainability, such as renewable energy and environmental protection, or companies with strong social and governance records.

Investors can use or combine one system or the other.

🖐️ The Securities and Exchange Commission is currently discussing rules that would make SEC disclosures mandatory in companies’ annual reports, which could make selecting an ESG portfolio easier.

ESG Mutual Funds and ETFs

Screening companies for ESG ranking is not easy and requires extensive research. If you don’t have the time or expertise to conduct your own screening process, consider using mutual funds or Exchange-traded funds (ETFs) organized according to ESG principles.

Mutual funds and ETFs are similar. Both are packages of stocks or other investment vehicles selected by fund managers. They have several other important differences.

Exchange Traded Funds (ETFs)

ETFs are bought and sold on exchanges just like stocks. You can buy and sell at any time. They track a stock index and usually have relatively low management fees.

Mutual funds

Mutual funds are not traded on a stock exchange. When you buy shares, you buy from the fund and trades take place at the end of a business day. Some closed-end funds may be fully subscribed and shares may not be available. Mutual funds can be managed passively or actively. Management fees are usually higher than ETFs and some funds may have significant minimum investments.

Pros and cons

A mutual fund or ETF fund achieves a higher degree of diversification than selecting stocks yourself, and takes much less time: professional managers do the screening for you. The downside is that you may have to look for funds that fit both your values ​​and your investment goals.

Most ESG ETFs track one of the many ESG-focused indices now available. For example, the popular Invesco MSCI Sustainable Future (ERTH) ETF tracks the MSCI Global Environment Select Index.

ESG mutual funds can also track an index, but many are actively managed. The fund managers themselves assess the companies and select those that meet the fund’s ESG criteria. This allows you to select a fund with criteria that closely match your one asset, but also pay higher management fees than an indexed fund.

☝️ Whether you choose a mutual fund or one of the best ESG ETFs, you should carefully examine the fund’s holdings and ESG criteria to ensure they are consistent with your values ​​and your investment goals.

Is ESG investing profitable?

It’s important to make investments that reflect your values, but most investors also want returns.

ESG supporters point out that companies that meet the ESG criteria are likely to be forward-looking companies with a strong future and less likely to experience environmental compliance issues, labor disputes or internal scandals.

In general, investors seem to believe that ESG investments are profitable. A poll in 2021 found that only a small minority found ESG investing unprofitable. 69% of frequent investors classified ESG investments as “highly profitable” or “somewhat profitable”.

ESG Investing Profitability Survey

Real studies of ESG and non-ESG portfolio returns have yielded mixed results.

A Morgan Stanley study found that “sustainable equity funds” outperformed mainstream funds by 4.3 percentage points in 2020. Reuters reported that ESG funds fell 9.2% in January 2022, against a 5.3% drop in the SPX, mainly driven by declines in the technology sector. sector. A study by Vanguard Funds found that “ESG funds do not have systematically higher or systematically lower raw returns or risks than the broader market.” this will continue.

In short, the returns generated by ESG funds do not appear to be worse than the market in general and could be better in some periods.

Some questions about profitability

Not all investors agree that ESG investing is profitable. Opponents point out that ESG criteria remove entire sectors from investment portfolios, reduce diversification and eliminate potentially profitable investments. They also argue that judging companies on non-financial grounds is inconsistent with the entire premise of investing.

These voices also cite evidence.

Why the differences? One reason may be that some ESG investment decisions may be based on voluntary ESG disclosures or signing of the United Nations Principles of Responsible Investment, rather than actual ESG performance. ESG investors can reward companies that talk about ESG principles rather than those that actually follow them.

Different investors and different analysts may also have very different definitions of “ESG investing”.

Studies conducted under different market conditions may also yield different results. Many ESG funds are tech-heavy and thrive in expansive periods when investors reward technology stocks. They may underperform during contraction when investors prefer stability and dividend payments.

A decision for every investor

ESG investing is here to stay. It is an increasingly popular strategy that has yielded satisfactory results for many investors.

If you decide to adopt an ESG strategy, you will need to make a number of decisions. You will need to decide what your personal ESG criteria will be and you will need to select investments – be they companies or funds – that meet those criteria.

That will take some work, but once it’s done, you’ll have money invested for retirement and the assurance that your investments won’t undermine your personal beliefs.

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