ESG is short for Environmental, Social and Governance. This investing strategy aims to minimize the adverse impacts of a portfolio on non-financial factors by allocating capital toward sustainability-focused investments.
Non-monetary factors are not mandatory to disclose for companies as part of financial reporting requirements.
However, asset managers such as pension funds, endowments and others are shifting toward assessing the environmental, social and other impacts of their investing footprint in public and private markets.
ESG investments bridge a critical gap toward long-term sustainability while reconciling with the present consumption of natural resources from the environment.
Large public and private companies are important stakeholders to ensure that sustainability-linked issues are weighed in while making business decisions and conducting financial planning.
By virtue of being stewards of capital, institutional money managers have now been actively contemplating the massive long-term impacts of funding specific polluting industries such as oil and gas and what steps they can take to promote sustainability initiatives, using corporate sponsorship and capital markets activities.
As a result, when funds invest using such factors, the approach is collectively called ESG investing and is intended to make a difference in the world by rewarding ESG-compliant businesses and divesting out from polluting sectors.
How Does ESG Investing Work?
ESG investing can sometimes be a wide, catch-all expression that seeks to capture a range of factors positively affecting the environment and society.
Using environmental, social and corporate governance characteristics as a lens to score businesses and investing opportunities is at the center of how ESG investing works.
Oftentimes, independent thought leaders and agencies produce a list of ESG compliant companies aiding the ESG due-diligence process as asset managers can benefit by outsourcing such sustainability expertise to make better ESG-related investing decisions.
By identifying these factors to judge the extent of sustainability initiatives that a business has adopted, investors are better equipped to create a measuring scale to rank these enterprises and assign appropriate ratings to curate investible ideas.
Overall, investors vote with their dollars to back socially responsible companies as these non-financial factors will gain an increased importance in valuing businesses.
Those owning such assets will receive a premium from the marketplace for making socially-conscious capital allocations.
Key ESG Investing Metrics
While ESG stands for Environmental, Social and Governance factors, the broader term looks to incorporate a range of topics that all contribute to more socially responsible outcomes for the company.
Some of these ESG investing metrics include:
Diversity and Inclusion
Businesses have gained a better appreciation of building a diverse and inclusive workforce as it better represents their customers while promoting stellar corporate values and greater inclusivity.
Carbon Footprint
Climate change initiatives begin with measuring and reducing an enterprise’s carbon footprint on the environment before finally eliminating it.
This is one of the major ESG investing metrics that investors use while making socially responsible investing decisions.
Health and Safety
Promoting the health and safety of employees is often a critical objective of management as this improves morale, enhances productivity and reduces employee turnover.
Furthermore, favourable safety records represent strong operational efficiency and risk management by staff while conducting day-to-day operations.
Product Safety
ESG investors pay attention to the effect of the products being sold on the community and how customers are interacting with these products.
Product safety also incorporates safety data pertaining to replacements and recalls, lawsuits and customer and employee safety as any adverse incidents can cause substantial reputational damage and a crisis of confidence affecting long-term prospects of the business.
Business Ethics and Corporate Governance
Investors expect a high standard of integrity from company management and the avoidance of any potential conflicts of interest that will enrich a small group of stakeholders at the expense of the organization or broader community.
While business ethics are table stakes for any company, it is important for ESG companies to exert pressure on their supply chain partners and hold them to those high standards as well.
Did You Know?
In the aftermath of the COVID-19 pandemic, ESG funds outperformed the S&P 500 in the first year of the recovery, returning as much as 27.3% and 55% in comparison to 27.1% for the S&P 500.
Pros of ESG Investing
Regulatory Compliance
Companies proactively thinking about the ESG impacts of their business operations will remain ahead of impending compliance requirements and regulatory changes in their industry.
Increased complexity and uncertainty around compliance in any industry affects long-term growth prospects and pushes investors away from that sector.
However, companies that focus on sustainability are well-positioned to navigate such changes in regulations.
Funding Costs
With the ever-increasing desire of asset managers to invest in sustainable investments, companies that are looking to fund green projects and sustainability-linked initiatives are able to tap capital markets at a premium and raise funding at attractive terms as there is always demand from asset managers to deploy capital into ESG-compliant projects.
Strong Return Generation
Investors might be under the impression that ESG investments compromise on returns in order to be sustainable, which might seem like a logical conclusion.
However, studies have shown that companies that incorporate sustainability, as well as other ESG considerations into their operations and decision-making processes are better able to serve their stakeholders, thereby promoting long-term business growth.
Reduces Volatility
Companies that incorporate ESG ethos into their business operations often have superior risk controls and a better handle on managing various stakeholder relationships with their employees, customers, regulators and the environment.
As a result, these companies are less likely to have negative PR surrounding their business dealings and potentially less detriments on their brand and goodwill.
Cons of ESG Investing
Investable Universe
ESG investors might find it hard to have adequate deal flow in order to diversify their holdings and get a wider exposure to different asset classes or businesses within a particular ESG theme.
As a result, this causes investors to chase after the same few deals, thereby stretching valuations and making it hard for investors to buy in at reasonable levels.
Qualitative Factors
Measuring ESG factors that are non-monetary in nature sometimes involves hiring industry experts and third-party professionals where it might be hard to pinpoint the exact value of an investment without making assumptions and using reasonable judgement.
This is different from valuing other securities that often have certain sets of rules that exist to value them.
However, with the passage of time, valuing such investments will become fairly streamlined and the variance between valuations given by different experts will be reduced.
Cost Structure
For retail investors, ESG funds might be significantly more expensive than passively managed index products.
ESG Index ETFs have a MER on average of more than 80 basis points while passively managed index funds charge less than 10 basis points annually.
Having said that, a large percentage of the index is concentrated in technology stocks having better ESG characteristics which means these passive index ETFs are more ESG-friendly than what would meet the eye.
Portfolio Construction
If an investor focuses on creating an ESG-compliant portfolio, they may be forced to omit certain industries such as oil and gas or tobacco.
By taking such an ethical stance, they might lose out on diversification opportunities.
Why is ESG Investing Important?
Despite how simply we can summarize an investor’s performance into dollars and cents, it is becoming more and more critical to examine and assess the impact that asset allocators have on the broader global economy beyond financial aspects as no business can perform without cultivating and nurturing a stable, productive relationship with its external and internal stakeholders.
Companies and investors funding these businesses will sooner or later make ESG-based decisions a non-negotiable as the long-term impacts of not being ESG compliant will be more expensive and drag investment performance.
Can I make money with ESG Investing?
Definitely! Investing in ESG compliant portfolios might not outperform the index every year but it’s certain that quality businesses will gain market share and will earn a premium valuation as a result of building sustainability into their operations.
For example, Apple (AAPL), one of the world’s most valuable companies is considered a pioneer in sustainability.
Anyone investing in a basket of leading companies focused on ESG will find it to be a worthwhile investment and not a drag on the portfolio as the long-term benefits outweigh the present-day costs when making ESG-related investment decisions.
Frequently Asked Questions
- What are some examples of ESG Investing?
- Where can I find ESG stocks?
