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.
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:
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.
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.
A 2020 study by Marsh & McLennan Companies found that:
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.
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?
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.
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.
|MSCI ESG rating system|
|Average||A, BBB, BB|
|Sustainalytics ESG rating system|
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.
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.
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 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.
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 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:
You can also consider using Charles Schwab’s SRI Fund List to guide mutual fund selection.
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:
You can also consider funds listed on ETF.com’s Socially Responsible ETF Channel.
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.
Now that you know about ESG investing, you can take active steps toward using socially responsible investing strategies in your portfolio, including