We all want our choices to matter, and that includes how we use our money. It's natural to wonder if your investments can build the future you want to see while still helping you reach your own financial goals.
What ESG actually means
ESG stands for Environmental, Social, and Governance. At its core, it's a way to evaluate how well a company is performing in these three specific areas.
Environmental factors look at how much energy a company uses or if they're using sustainable materials. Social factors examine how the company treats its employees and whether they're making a genuine effort to be inclusive and diverse. Finally, corporate governance focuses on transparency and accountability to ensure the company is run ethically and responsibly.
This approach has become increasingly important to investors who want to align their dollars with their values. It allows anyone to put their money where their heart is. To demonstrate their commitment to these sustainable practices, many companies now provide ESG reports or disclose this information as part of their standard financial reporting.
The rise of ESG investing
ESG investing is simply a sustainable investment strategy that considers these environmental, social, and governance factors. It's designed to align your values with your financial objectives by selecting companies that demonstrate strong performance in these areas or by supporting industries that champion ethical causes.
This style of investing has grown in popularity recently. According to Morningstar, global assets in ESG funds rose to approximately $2.5 trillion by the end of 2022. This is a significant jump from $2.24 trillion at the end of the third quarter of that same year. Because of this demand, many investment companies now offer ESG-focused products like mutual funds or exchange-traded funds (ETFs).
How ESG scores work
Most ESG scores are calculated using publicly available data sets from sources like Bloomberg or MSCI. These scores look at quantitative indicators, such as greenhouse gas emissions or employee diversity, as well as qualitative surveys of stakeholders. The scores are then compared to an industry benchmark or peer group to see how the company stacks up.
Investors can use these ratings to understand a company's potential long-term risks or identify opportunities for impact. Additionally, these scores can inform corporate engagement activities, such as voting on shareholder resolutions or engaging directly with companies to address specific environmental or social risks.
Clearing up the confusion between ESG and SRI
Socially responsible investing (SRI) sounds a lot like ESG investing, but there are differences you should know about. In the past, sustainable portfolios were constructed differently depending on whether they used an inclusionary or exclusionary approach.
For example, SRI traditionally implemented an exclusionary approach to weed out "sinful" investments like gambling or alcohol stocks. While ESG strategies avoid these companies as well, they also actively include companies that generate a positive impact.
Inclusionary vs. exclusionary strategies
Inclusionary strategies seek out companies that meet specific ESG criteria, such as strong environmental practices, diverse leadership teams, or ethical business practices. The goal here is to encourage positive change by integrating these companies into the portfolio.
Exclusionary strategies, on the other hand, screen out companies that don't meet specific criteria. This usually means avoiding those involved in controversial industries like tobacco or weapons manufacturing to avoid supporting negative social or environmental impacts.
As sustainable investing has ballooned in popularity, these terms have bled together, but the distinction remains important.
Common ways to invest in ESG
The most common vehicles for ESG investing are mutual funds, ETFs, and individual stocks.
ESG-focused mutual funds are baskets of stocks that may screen out companies engaging in harmful practices or those with poor labor or governance records. Exchange-traded funds (ETFs) are similar to mutual funds but trade like stocks on an exchange, meaning they can be bought or sold throughout the trading day.
Stocks are the riskiest option because investing in just one or a few individual companies lacks diversification. If you truly believe in a particular business, don't skip over researching the company's fundamentals to make sure it's a sound investment.
The benefits of ESG investing
There are several reasons you might consider this approach for your financial roadmap.
- Potential for better returns: Some research suggests that companies with strong ESG performance may be more resilient and financially successful in the long term, which could lead to better returns.
- Alignment with values: This approach allows you to align your portfolio with your social and environmental values, providing a sense of personal satisfaction.
- Positive impact: You can contribute to outcomes like reducing carbon emissions or advancing social justice causes.
- Increased transparency: By encouraging companies to report on their performance, this investing style promotes accountability which benefits stakeholders and society as a whole.
The drawbacks to consider
While popular, there are valid reasons why some investors choose not to participate in ESG investing.
- Limited investment options: Despite growth, the selection of ESG products is smaller than traditional options, which can make it difficult to achieve full diversification.
- Potential for lower returns: While some studies show outperformance, there is also evidence that ESG investing may result in lower returns, especially in the short term.
- Lack of standardization: There is currently no standard definition for ESG factors. This makes it challenging to compare companies and can lead to inconsistencies in reporting.
- Potential for greenwashing: Greenwashing refers to the practice of companies making false or misleading claims about their environmental or social performance. This can mislead investors who are genuinely looking for sustainable options.
- Higher fees: Some ESG products charge higher fees than traditional ones, which could eat into your returns and impact your long-term financial roadmap.
The Facet difference
At Facet, we believe your money is a reflection of your values, but we also believe in looking at the whole picture. We don't just chase trends. You'll work with a CFP® professional who helps you weigh the emotional satisfaction of ESG investing against the practical realities of fees, diversification, and your long-term goals. Our flat-fee membership model means we never make money on the specific funds you choose, so our advice is objective and focused on your best interests.
