ESG investing has gained traction in recent years, but not all funds are the same. How do you know if your investments are aligned with your personal ESG hierarchy?
Think about values important to you, whether environmental, social, governance, or some combination
Do your research and look closely at investment vehicle holdings
Don’t forget returns—make sure the funds are consistent with your objectives and risk tolerance
Environmental, social, and governance (ESG) investing has become an increasingly popular choice among investors, particularly among young investors.
A recent report by US SIF, a group that tracks sustainable investing, shows that one-third of total U.S. assets under professional management (about $17 trillion) use sustainable investing strategies.
As the ESG investing style has grown, it’s led to more ways to invest, including mutual funds and exchange-traded funds. But ESG-focused funds aren’t all the same. Although there are some broad-based funds that try to incorporate all three pillars of ESG, many funds concentrate on just one criterium. In 2020, US SIF identified 718 mutual funds and 94 ETFs that consider ESG criteria, so there’s potentially an investment vehicle to suit anyone.
How can an investor know which style is aligned with their personal ESG hierarchy? As with any investment, it takes a little homework.
Creating a portfolio of ESG investments? According to Viraj Desai, senior portfolio manager at TD Ameritrade Investment Management LLC, you might want to consider two aspects: ESG suitability and asset allocation. First, it’s important to think about what’s most important to you. Here are a few factors to consider for each pillar.
You might be an “E” investor if you:
• Want companies to reduce carbon emissions
• Look for energy efficiency
• Are concerned about mitigating air or water pollution
You might be an “S” investor if you:
• Look for companies with diverse workforces and workplace policies
• Are concerned about animal testing on products and other product safety
• Consider how a company protects customer privacy
You might be a “G” investor if you:
• Look at board composition and structure
• Are concerned about executive compensation
• Are interested in a company’s strategic sustainability oversight
It may be unlikely any company is going to excel at all three pillars, so it might be important to narrow down and rank criteria you want a company to get right. For example, electric car and battery maker Tesla (TSLA) tends to get high marks on the environmental pillar for creating electric vehicles as a way to combat climate change. However, some ESG raters have dinged the company on workplace protection and safety measures. Facebook (FB) scores highly for having low greenhouse gas emissions, but data privacy issues have cut into its “S” score.
Also, some companies are changing how they do business. Look at some of the major oil investments that are heavily investing in renewable energy, such as Total (TOT) and Royal Dutch Shell (RYDAF). Although they still mine fossil fuels, both are considered leaders in reducing toxic emissions and waste, and are making strides in carbon emissions, according the MSCI ESG ratings.
Investors who are focused on environmental concerns might look for a fund that devotes most of its assets toward companies trying to help mitigate climate change or have other earth-friendly policies. And then there are religious-based funds, which have been around for a long time. Such funds include both Christian-values and Shariah-compliant funds.
Investors interested in governance may have a harder time finding funds specifically focused on this pillar, but often funds that lean heavily on one factor or another may include a stewardship screen. This can go beyond boardroom diversity to include assessing how companies interact with their communities, as well as the products and services they offer.
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Knowing if a company’s ESG score aligns with your personal interests starts by understanding the firm’s ESG risk. It’s important to center on the ESG risk to a company’s financial well-being. A good place to start is the Sustainability Accounting Standards Board (SASB) Materiality Map.
SASB identified 26 sustainability-related business issues that cover a range of disclosure topics and their associated accounting metrics. For example, financial firms have few environmental risks, but they are at risk for lapses in business ethics or systems risk management or may have issues with selling practices, which fall under the social and governance factors. Similarly, a mining company may have serious exposure to environmental risks but few risks when it comes to factors such as data security.
Desai explained that when his team works with a client on portfolio allocation, its goal is to understand a client’s motivation: whether the client wants to exclude certain products (such as tobacco or weapons), seek out companies that are strong in particular areas, or just wants a portfolio of companies that are more socially aware.
Investors who use ESG mutual funds and ETFs may want to consider looking beyond the name of the fund to make sure it aligns with their personal values, whether it’s to exclude or include certain companies. Research firms like Morningstar and As You Sow offer tools to investors that allow for a quick review of both holdings and performance.
For investors who want vehicles that are more socially aware—but are less concerned about specific company exclusions—they could consider taking a more holistic approach and look at ETFs that try to replicate the return of the broader markets. This newer crop of broad-based ESG ETFs seek to balance return while choosing companies with higher ESG ratings from each sector (e.g., Technology, Energy, and Financials). Holding companies from each sector may mean that such a fund includes, for example, traditional energy producers—which may have higher environmental risks but score well on social and governance factors.
Investors who want their investments to affect positive change may want to seek out actively managed ESG funds where the managers select what they think are the best-performing stocks, but may also engage in shareholder advocacy or proxy voting. These funds can come with higher fees to compensate the manager.
Finally, while considering ESG factors, don’t forget the reason you’re investing in capital markets in the first place—to seek asset appreciation. Be sure to look at a fund’s performance and fees to see if it’s consistent with your objectives and risk tolerance.
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