- Ethical investing begins with ESGs: environmental, social and governance.
- There are ESG mutual funds and ETFs and ESG scores to help evaluate companies.
- Ultimately, you need to decide what kind of impact you want to have and then invest your money.
Environmental, social and governance (ESG) investing has recently made headlines, from the Wall Street Journal series, Why the Sustainable Investment Craze is Flawed, to Morningstar’s rebuttal that sustainable investing is part of a long-term shift in the way people get closer to their investments. Many people are wondering how to think about ESG investing and how to get started.
According to Barrons, US ESG mutual fund and ETF assets rose to a record $ 400 billion in 2021, a 33% increase from the previous year. Despite this strong growth, the overall market share is negligible, with just 1.4% of total US mutual fund and ETF assets.
With some conflicting views and huge market potential, it’s hard to know where to start. Here are three things to consider before starting with ethical investing.
1. What are you prioritizing and why?
There is no true and universal definition of socially responsible investment. It is up to you to determine and define. Start by asking yourself: What are my values? What do I really care about? How do I express it through my actions? Business guru Simon Sinek would call this determining your “why”. You will need it to guide you through an ethical investment journey.
The ABCs of ethical investing are ESGs: Environmental, Social and Governance. The environment includes things like a company’s energy use, waste, and pollution; Social can be a company’s gender equality, diversity efforts and inclusion, and community investment; and governance can include compliance, such as ensuring that companies avoid illegal practices, have transparent accounting practices, and offer shareholder interactions.
ESG is a big umbrella term and it can mean different things to different people. There are an unlimited amount of problems in the world and many ways to deal with them: without any focus, it is difficult to have transparent reports and results. Start by defining the problem you are trying to solve or the cause you are fighting for.
2. Do your homework
Now that you have a specific goal in mind, it’s a lot easier to get to work. Spoiler Alert: Not all ESG funds are created equal. If you don’t do your own research or hire someone else on your behalf, make sure you get the impact you think you have.
Take ESG scores for example. These scores are calculated by investment firms who create their own scoring models to assess a company’s ESG impact. If this is your only basis of comparison, it is important to know that a company’s ESG assessment is very subjective and often lacks focus on what is actually being measured.
What may interest you as an investor may not be fully captured in the scores. This is because there are dozens of underlying metrics for each of the ESG parts / scores. For example, in the Social category, or “S”, a score could reflect employee safety, work relationships, business ethics, etc. Not all factors are equally relevant to every company. Many of these variables are not widely available and, if they are, they are not checked. The outputs, or scores, are only as good as the inputs, or “qualifications”. So, before comparing scoreboards, be sure to consider the source.
Even the rating providers themselves do not seem to agree with each other. Search affiliates looked at the top 20
companies in the United States and has shown cases where two suppliers may have valuation differences greater than 25%. Facebook, or now Meta, had an E-score of .77 from one provider and .23 from another. This significant difference is difficult for the average investor to decipher and understand.
Ultimately, you want to be able to define the goal you are looking for and how you will measure the result. The intermediate can be thought of as the “Come” in Sinek’s Why, How, What Bullseye. In other words, this is it such as do your “why”.
Not long ago you probably had to sacrifice some return to invest in a value-based portfolio. Not so much anymore. While it is important to note that there is currently no known or evidence-based premium for sustainably investing, it does not need to cause underperformance either. Evidence shows us that we can achieve similar, high-quality investments with similar returns to a non-ESG fund, provided we do it well and adhere to sound investment principles such as diversification, lost costs, low turnover, etc.
A few more honorable mentions: do not be obsessed with comparing your “traditional” investments with the performance of your “sustainable” investments using the same indices as a benchmark. This is true if your sustainable strategy is intentionally “excluding” or minimizing a particular sector, such as oil and gas. Compared to the market, it will be inherently different from the design. Understand that traditional investment benchmarks can only be a rough approximation and not a true apple-to-apple comparison.
Another easy criticism of ESG investing is the lack of diversification or exclusion of certain sectors within the funds. Many economists would warn against this, with the argument that completely kicking out sectors or industries is shortsighted. It takes the entire economy to manage the world, and doing so reduces the diversity of the fund. Eventually, eliminating sectors could leave you with an overweight to large-cap tech companies. A good practice here might be to exclude or re-weight, but not focus.
3. What are you going to do?
For my company, Uplevel Wealth, our “what” is providing a great investment experience, while addressing sustainability-oriented outcomes, particularly with regards to climate change and the reduction of greenhouse gas emissions.
What do you focus on? How do you measure the results? Are there any additional “returns” you are looking for, perhaps social and personal?
Sustainability investment expert Sam Adams attributes his social return to a simple preference for buying more organic foods. In doing so, he hopes the demand for sustainable agriculture will increase, driving best practices and farming overall.
Adams also notes that the weather is changing, storms are getting stronger and we are seeing more floods and fires. Are the companies we invest in prepared for these changes? Are you interested in investing in companies that are paying attention to these things?
Long-term ESG investors have many reasons to be optimistic about the future. Seven out of ten largest pension funds in the world invest in sustainable funds, which will continue to put pressure on large corporations to bring about positive change. Additionally, the Securities and Exchange Commission just proposed new rule changes that require companies to report their greenhouse gas emissions and details on how climate change is affecting their businesses. We are confident that markets will perform better with more standardized information and the new SEC disclosure should help achieve better results.
While it’s not always easy, the message remains consistent: Much investment requires you to take the good with the bad. Staying focused and disciplined, regardless of the ESG strategy, is what leads to future long-term rewards.