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What is ESG investing, and is it worth it?

by | Last updated 26 Nov, 2022 | Investing Strategies

ESG investing has emerged in recent years as investors adopt new responsible investment strategies to achieve their financial goals. The shift toward sustainability through investments arises from the realisation that the impact of corporations is felt by everyone and everything in society and the environment.

But what does becoming an ESG investor actually mean. And is it even worth it?

What is ESG investing? 

In many instances, the term ESG investing is used interchangeably with “socially responsible investing”, “ethical investing”, “impact investing”, and “sustainable investing”. But there are subtle differences.

ESG stands for Environmental, Social and Governance. It’s the idea of buying shares in businesses prioritising environmental, social and governance factors. In other words, investors like this investment strategy because it enables them to enjoy profits while simultaneously improving the world as we know it.

This movement is built from three key pillars that each have their own set of ESG factors analysts tend to look for:

  • Environmental – How is the company handling their impact on climate change? How much greenhouse gases does it emit? How destructive is the firm in regards to resource depletion? What safeguards are in place to prevent waste and pollution? Does the business support biodiversity?
  • Social – Are there equal opportunities for all genders and races within the firm? Does management emphasise maintaining high-quality working conditions and cultivating a positive employee culture? Does the business respect human rights?
  • Governance – What does the group’s business ethics track record indicate? Are there allegations of corruption and bribery? Is executive pay reasonable relative to other employees? Does the firm comply with industry regulations?

Combined, these factors help an individual or an investment manager determine whether a business is a viable ethical investment.

How did ESG investing start?

Despite only recently getting the headlines, ESG investing has actually been around for decades. In the 1960s, investors began excluding tobacco production companies from their portfolios due to their involvement with the institutionalised racial oppression of the Apartheid regime in South Africa.

But the actual term ESG didn’t come about until October 2005, when the United Nations Environment Programme Initiative coined it in its Freshfields report.

Over time the standards required for being an ESG-compliant company have evolved. And today, almost every company has a section in their annual report dedicated to explaining how it tries to maintain the highest environmental, social, and governance standards. This helps ESG investors identify stocks and funds that might be worthy of being added to a portfolio.

Does ESG investing deliver higher returns?

Given that some form of the ESG investing style has existed since the 1960s, it can deliver a strong financial return, right? Unfortunately, that remains unclear.

The ESG data collected so far has been mixed. A lot of research has concluded that in the pursuit of improving ESG scores, companies have had to increase spending without delivering extra tangible value. In other words, profitability suffers, taking the stock price with it and generating lower returns. But there is an equal proportion of research that says quite the opposite.

Fidelity examined a variety of ESG investments between 1970 and 2014. And based on its research discovered that half of all ESG investments beat the stock market, with only 11% performing poorly.

Additional research from BlackRock demonstrated similar results. It found that 8 out of 10 sustainable investment funds out-performed non-ESG funds during the height of the 2020 pandemic.

In another important finding, Morningstar found that ESG funds generally had lower volatility with a good return on equity, as well as a longer lifespan. As per their report, 77% of ESG funds launched ten years ago continue to operate today versus only 46% of conventional funds during the same period.

Part of these conflicting results stems from a lack of a clear definition surrounding ESG companies. After all, ESG criteria are largely subjective in nature and up to interpretation. Sadly this opens the door to a lot of mischaracterisation. There are countless corporations that proclaim their dedication to ESG principles despite doing little or nothing to improve society, combat climate change, or elevate employee work standards.

How to choose an ESG investment

In deciding on ESG stocks or investments to make, there are some factors to consider. 

Investors should decide on how they want to enter this space. Investing in individual stocks opens the door to more impressive returns. However, this requires a lot more research, dedication, and emotional discipline, that many individuals lack.

Alternatively, all these investment decision headaches could be passed onto investment professionals by investing in an active or passive ESG fund. According to the US Social Investment Forum, there are approximately 836 sustainable funds to choose from, 94 of which are ETFs. But this option comes at the expense of annual fees.

Investors should also look at the ESG strategy companies deploy to improve their positive impact on the world. If an investor has chosen to go the route of a fund, then it becomes a matter of finding out how the fund manager selects businesses for the ESG portfolio. If there is little detail surrounding this decision-making process, chances are the fund is not as responsible as it suggests. This can be verified by looking at the top ten positions in the portfolio.

Lastly, for individual ESG stocks, investors ought to look at their compliance history. It’s useful to hear what management is saying. But more importantly, how they’re planning to achieve their goals and whether or not they’ve hit historical targets.

Final takeaways

ESG investing is still evolving. But as more investors adopt this investment style, the pressure is on for companies to improve their environmental impact, social standing, and governance decision making.

An ESG investor is willing to accept a lower return on investment if it means the world is not exploited for profit. After all, without a thriving society, a healthy environment, and responsible corporate leaders, businesses will not be able to thrive in the long term. That’s why the ESG movement has become so popular.

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Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and, therefore, may differ from the opinions of analysts in The Money Cog Premium services.

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