“You can change the world with your investment strategy” - that might seem like a reach to some, but that’s the very idea with ESG.
Impact investing is a type of investing designed to help benefit the world and add to the investor's bottom line at the same time. Impact investors can focus on any social issue that matters to them, including poverty, faith-based issues, or clean water.
With the growing number of environmental, social, and governance (ESG) funds, many people wonder what they are and how they differ from other types of mutual funds or exchange-traded funds (ETFs).
In this guide, we’ll attempt to go over what ESG funds are, who manages them, and what they invest in to give you a sense of whether or not they’re right for your investment portfolio.
Why Invest for Impact?
Ethics and financial returns can both play a role in impact investing. Investors looking to reduce their environmental impact while still making money might want to add “green funds” (which focus on companies with sustainable business practices) to their investment portfolio.
According to Morningstar, if you had invested in a green fund tracking MSCI's All Country World Index of green stocks in July of 2017, your shares would have doubled in value by July of 2021. Over a 4 year period, that’s an average annual return of roughly 19% on your money. That’s not bad! But green funds are still fairly new, not well defined and whether such returns will continue, remains to be seen.
What are Environmental, Social, and Governance (ESG) Funds?
A green revolution is underway, and companies are finding new ways to capitalize on it.
Environmental, social, and governance (ESG) funds can offer you a way to invest in sustainable companies through exchange-traded funds (ETFs) or mutual funds. These funds consider environmental, social, and governance issues such as climate change, social injustice, leadership, and more. Often using complex algorithms they will look for key environmental and social factors that can have a significant impact socially and on the businesses over time.
A number of companies are looking to shift their attention toward sustainability—and they are hoping they will be rewarded with increased profits in a growing market. As climate change continues to be a hot topic around the world, interest in greener options are likely to continue to grow as well. Investors have a lot of different choices when it comes to putting money into “sustainable” companies.
Here are some examples:
Green bonds are issued by corporations and governments to raise capital for environmentally friendly projects like renewable energy infrastructure or pollution reduction initiatives. These bonds typically pay out lower rates than other types of debt but may also come with less risk because they’re backed by tangible assets like solar panels or wastewater treatment plants.
Green funds may invest in large-cap stocks within specific sectors including energy, transportation, agriculture, chemicals, and utilities—as well as smaller companies within these sectors that exhibit characteristics such as reduced carbon footprint, greenhouse gas emissions, or high resource efficiency ratios.
Social funds may target companies that are actively working to address challenges within the workforce and the community. Companies addressing issues like diversity, income inequality, child labor, and women leadership. In some cases, they may exclude, or screen out, companies based on the product they produce, or past violations around labor rights and anti-corruption.
There’s only one problem, these funds don’t all define the E, S, and G part the same. It often comes down to the “lens” through which they view these issues. ESG ratings, scores, and metrics can differ widely depending on who's scoring them. While the environmental side of ESG can be driven by hard data (measuring gas emissions etc), the social and governance side often requires some interpretation. There is no standardized way to measure a company’s impact on a given issue.
What Does ESG Stand For?
There are several types of environmentally sustainable funds (ESGs). The term ESG refers to environmental, social, and governmental factors in specific funds. Every ESG fund is unique but each will focus, to a greater or lesser degree, on any or all of these three aspects.
The first aspect is environmental. ESG funds with an environmental direction will often focus on a company's potential impact on the environment. Sometimes called a green or clean fund, these investments might focus on individual environmental initiatives, such as clean air or water, or they may be more general in scope.
The second type is social. Some ESG funds invest heavily into a company's impact on its employees and community. These funds often consider programs and practices between the company and its employees, suppliers, clients, and communities.
The third factor is governance. This looks at how a company is managed and by whom it is led. Researchers focus on the corporate board and executive leadership before classifying these funds as "ESG."
Where Can You Find ESG Funds to Invest In?
ESG funds have grown in popularity, and today, there are hundreds of such options on the US stock exchange. Most big funds companies such as Fidelity, Vanguard, and iShares carry ESG funds. Even robo-advisors like Bettermint and Wealthfront offer socially responsible strategies.
Selecting a socially responsible fund can, however, be a challenge. Not all ESG funds are equally invested in social or environmental change. While online ratings can help sort and rank these funds, talking to your financial advisor is probably your first step. They may be able to help with ESG strategies or guide you towards options that are aligned with your overall goals.
What Types of Investors Are Using ESG Funds?
Judging by their growing popularity, ESG funds are appealing to a wide range of investors. All who have at least one thing in common - are considering the social, environmental, and/or governance factors of their investments.
The main groups of investors using these funds include individuals, institutional investors, organizations, and foundations.
Individuals who are targeting ethical and environmental factors in their investment decisions. They may be concerned about making a difference through the companies they invest in or want to avoid investing in companies that do not align with their values. In some cases, they may be hoping to improve their risk/return profile.
Institutional investors see the growing demand among consumers and want to give their clients access to the ESG space. Foundations or organizations want to support causes that matter most to them.
ESG investing likely isn’t the solution to problems like climate change, social injustice, or inequality, but for some, it can be a way to get involved.
With all this positive news about ESGs, why isn't everyone investing in them? There's a lot to consider before making any investment.
Pros & Cons of ESG Funds
Funds that market themselves as ESG funds may appear to be more ethical than conventional funds — at least, you’d hope so. They're often screened for companies in industries that produce harmful pollutants or tobacco and may avoid companies that have a poor track record when it comes to employee relations. But in some cases, these same funds may hold companies that some investors might find puzzling. There are “sustainable” companies that hold defense industry stocks or oil and gas companies. Energy companies that may not score high on climate change, but make up for it in diversity and hiring practices.
While there’s still a great deal of “gray” in what defines ESG, ESG has gained substantial ground in recent years and is now considered a mainstream investment strategy.
But not every ESG fund is created equal. Some funds engage in a practice called greenwashing in which they mainly develop a socially conscious marketing message but with no initiatives of substance to support it. The hope for many investors is that New legislation would increase transparency into ESG funds.
Still, you’ll likely want to look into each fund's underlying methodology, or mission, to gain a better understanding of what you're investing in before putting your money down.
How Does Faith Fit into ESG Investing?
There are a handful of other investment strategies for “socially conscious” investors, including those looking to incorporate Christian, or other religious, values. Faith-based strategies, or Biblically Responsible Investing (BRI) funds, are focused on providing funds that align with Christian values.
There are funds that will exclude companies based on screens and filters, and funds that will focus on companies with themes that create value for society.
Faith-based investing may actually be one of the oldest forms of ESG investing. For example, 102-year-old GuideStone, which exists to support pastors and their widows, has built an $18-billion portfolio. They don't invest in any company that supports p*rnography, gambling, alcohol, tobacco, or abortion.
As stewards, we should use money in a way that aligns with our convictions and values. If you haven’t considered what those convictions are, spend some time with God (in scripture and in prayer) and see what he might be saying to you.
Factors to Consider When Investing in ESG
In order to make a decision on whether or not to invest in socially responsible funds, first you must consider your investment objectives and goals.
Do you intend to use these funds as part of your long-term retirement planning strategy? If so, consider using them in conjunction with other strategies including those that incorporate traditional stocks and bonds.
How do you plan to pay for college for your kids? This is an expensive proposition that many parents have to grapple with. Talk with your advisor about how various types of green or traditional investments can help fund your child’s education.
Are ESG funds part of the legacy you want to leave for your children? A legacy includes more than money. It's also about faith, character, and hard work. Could a portfolio with ESG funds be part of that?
Then consider if that ESG fund aligns with what you’re trying to accomplish or what you’re hoping to support.
If you have more questions about whether ESG should be part of your investment portfolio, contact us at Cooke Wealth Management today. We would love to talk with you.
