What Is ESG Investing? The Ultimate Guide - MagnifyMoney
Investing

What Is ESG Investing?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.
How MagnifyMoney Gets Paid ?
Advertiser Disclosure

Environmental, social and governance (ESG) investing examines how a company or investment’s policies and practices protect its employees, customers, communities and the environment. And if you’re an investor who values companies looking to do good in the world, this type of impact investing could be a consideration for your portfolio.

Why? Because research shows that companies and investments that rate highly on ESG factors can create a better world and deliver returns that can outperform their non-ESG-focused peers.

What is ESG investing?

ESG investing is a type of ethical investing where you consider a company’s sustainability factors when making investment decisions.

However, sustainability isn’t just about whether a company or investment respects the environment. ESG factors also consider how a company’s policies and business practices impact the world and the people in it, which can include:

EnvironmentalSocialGovernance
  • Climate change impact
  • Greenhouse gas emissions
  • Green energy initiatives
  • Waste disposal practices
  • Deforestation
  • Working conditions
  • Gender and racial diversity
  • Employee relations
  • Customer satisfaction
  • Child labor
  • Executive pay
  • Board diversity
  • Political lobbying and donations
  • Corruption
  • Lawsuits against the company

The theory behind ESG investing is that companies that score highly on these metrics also make lower-risk long-term investments. Why? Because they’re less likely to face costly lawsuits and regulatory penalties that can negatively impact their bottom line and your returns as an investor.

ESG investing trends

Is ESG investing merely a trend like meme stocks? While some politicians downplay the value of sustainable business practices, multiple groups view ESG criteria as critical components of their respective success.

High ESG scores can attract and retain talent

A 2020 study by Marsh & McLennan Companies found that:

  • Employers with the highest employee satisfaction ratings have ESG scores 14% higher than global averages.
  • Companies viewed as desirable employers by students and young professionals have ESG scores 25% higher than global averages.

High ESG scores help companies save on borrowing costs

Companies with solid ESG ratings can now leverage their high scores (more on scores in a minute) to lower their loan interest rates. In 2019, worldwide lenders issued a whopping $465 billion in sustainability-linked debt — a 78% increase over 2018 figures.

Highly rated ESG investments can help investors reduce risk

2020 research from the World Economic Forum found that more than half of the world’s gross domestic product (GDP) is “moderately or highly dependent on nature and its services, and therefore exposed to risks from nature loss.”

A 2022 report by Manulife Investment Management used those findings to suggest that investors can decrease overall portfolio risk through investments in companies with strong governance and ethical policies. By decreasing nature risk in your portfolio, you may reduce portfolio volatility — especially that caused by climate change.

So, is sustainability-centric investing a trend? We think not. It’s an ever-increasing focus for workers, companies, lenders and investors. But how do you identify if an investment is “good” from a sustainability perspective?

All about ESG ratings

Thanks to ESG ratings, it’s easy to find investments doing good in the world. Third-party research firms measure companies based on environmental, social and governance metrics and then provide a score as an overall picture of a company’s sustainability health.

But ESG ratings aren’t just a simple equation. Ratings also consider how certain factors can impact a company’s financial performance, called materiality. For example, deforestation has a more significant impact on the financial future of a furniture manufacturer than a bank.

What is an ESG score?

An ESG score is a number or letter grade third-party rating agencies give to a company or fund after examining its sustainability practices. The higher the score, the better the company or fund’s performance on ESG issues.

The most popular public ESG rating agencies are MSCI and Sustainalytics, which assign the following ratings to companies and funds:

MSCI ESG rating system
ESG performanceRating
LeaderAAA, AA
AverageA, BBB, BB
LaggingB, CCC
Sustainalytics ESG rating system
ESG riskScore
Negligible0-10
Low10-20
Medium20-30
High30-40
Severe40+

As industry insiders can access various other ESG ratings and scoring systems through subscriptions, don’t be surprised when you see scores that don’t fit the above two models. However, the two rating agencies above can help give you a good idea of a company’s or fund’s ESG initiatives as you research investments.

Inside the strategy: ESG performance

A common concern among investors is that you’ll have to sacrifice returns when using sustainable investing practices. Still, studies have repeatedly shown this isn’t the case. The opposite is often true, especially over the long term.

  • More than half of U.S. equity ESG funds are in the top half of their peer group for long-term performance (Morningstar).
  • In 2020, U.S. sustainable funds outperformed their traditional peers by 4.3% (Morgan Stanley Sustainable Reality Report).
  • Stock funds with more ESG-centric companies outperformed traditional benchmarks between January 2017 and April 2022 (ESG Book).
  • Companies with higher ESG ratings also had higher profitability and lower risk from both company-specific threats and overall market risks (MSCI).
  • As of June 2022, U.S. ESG stock funds have declined less (-13.5%) than their non-ESG peers (-15.3%) (Bloomberg).

For all of the benefits above, we’d be remiss if we didn’t fill you in on some of ESG’s investing downsides.

  • ESG funds can have higher fees. Sustainable funds tend to have higher expense ratios (0.61%) compared to their non-sustainable peers (0.41%), though costs are coming down.
  • ESG rating standards aren’t universal. Every company issuing ESG scores uses different weightings and metrics — even though there’s a move to adopt universal standards.
  • Advisor expertise can be tricky. Since ESG is a specialty, you might find it more difficult to find a financial advisor well-versed in sustainable investing.

Getting started: How to find ESG investments

ESG investments aren’t hard to find. You can use ESG rating search tools online at many of these top research firms or include an ESG metric in your investment screen on sites like Morningstar.

You don’t need to be a DIY investor to incorporate sustainable investing into your portfolio, however. Here, we’ll cover the different ways you can build yourself an ESG portfolio from easiest to most involved.

Prebuilt ESG portfolios

If you want some guidance with your ESG investing efforts, consider a robo-advisor offering ESG portfolios. Robos like Betterment, Wealthsimple, Earthfolio and Ellevest all offer sustainable investing options.

Just be aware that the fees may be higher than if you took a strictly DIY approach. But the price can be well worth the comfort of knowing you’ve got expert research at your back and someone else handling the day-to-day portfolio management.

ESG mutual funds

ESG mutual funds are an easy way to gain diversification without needing to sift through thousands of companies to find those with the top scores.

For some ESG fund ideas, consider some of Morningstar’s top-rated ESG mutual funds as of September 2022:

  • Parnassus Core Equity (PRBLX)
  • TIAA-CREF Core Impact Bond (TSBIX)
  • Brown Advisory Sustainable Growth (BIAWX)

You can also consider using Charles Schwab’s SRI Fund List to guide mutual fund selection.

ESG ETFs

ESG exchange-traded funds (ETFs) are another cost-effective route for DIY investors, with hundreds of options available and more launching each year.

As of September 2022, some ESG ETFs with top ratings from MSCI include:

  • iShares ESG Aware MSCI USA ETF (ESGU) — AAA rating
  • Vanguard ESG US Stock ETF (ESGV) — AAA rating
  • Nuveen ESG Mid-Cap Growth ETF (NUMG) — AAA rating

You can also consider funds listed on ETF.com’s Socially Responsible ETF Channel.

ESG stocks

If you’re a hands-on DIY investor and you prefer to invest in individual companies, consider ESG stocks. The easiest way to find ESG stocks is to use free screening tools and lists from companies like Morningstar, MSCI and Sustainalytics.

We recommend using scores from at least two ESG rating agencies before making an investment decision.

What’s next?

Now that you know about ESG investing, you can take active steps toward using socially responsible investing strategies in your portfolio, including

  • Opening an account with an ESG-friendly robo-advisor. Several top-notch robos offer options specifically for ESG-minded investors, from IRAs to taxable brokerage accounts.
  • Going the DIY route with an online broker. Add ESG-conscious holdings to your portfolio today with an online brokerage account — mutual funds, ETFs and stocks are waiting.