Environmental, Social, and Governance (ESG) investing has taken a front seat in the investment world. Individuals want to invest based on their values and institutions are mindful of investing in accordance with their shareholders’ or members’ values. But what exactly is ESG investing? Why would an investor choose this strategy? Finally, like with any other investment strategy, an investor must know that an ESG investment strategy offers benefits, but what risks or costs does ESG investing present?
What is ESG Investing? / How Does ESG Investing Work?
ESG investing, also commonly referred to as responsible investing, socially responsible investing, sustainable investing, etc., involves research and analysis of environmental, social, and governance issues, as well as common financial metrics, when considering securities for a portfolio. ESG factors such as climate change, human rights, or board of directors’ composition all could play a role in an individual’s decision to invest their money in a security (i.e. stock, mutual fund, exchange traded fund (ETF), etc.).i Then, based on a business’ stance or practice related to these factors, an individual may or may not invest in the business.
Ultimately, the main goal is to have an investment strategy that accounts for or reflects environmental, social, or governance values.
ESG investing continues to grow in popularity and relevance with each passing day. In 2012, assets under management of ESG investments totaled $13.3 trillion.ii By the start of 2018, that total increased to $30.7 trillion and, in 2019 alone, ESG assets under management increased over $20 billion.iii Investors are more and more alert to a business’ environmental effects, social ideology, and governance, and, as a result, these investors wonder how their voice and values can impact the businesses around them.
Why Invest in ESG?
The ESG investing trend appears to be driven by its impact and value, and not in the financial sense. An increasing number of individuals and institutions have begun focusing on how their investment decisions can have a positive impact regarding topics such as fighting climate change or enhancing humans’ overall well-being. For instance, when ESG investing began in the 1960s, investors would exclude companies or entire industries that had business activities involving or related to tobacco production so the investors’ dollars would not further the harm tobacco products could cause.iv By investing, or not investing, in businesses associated with “harmful” practices, the investor feels their contribution has made a positive impact on the world by not aiding a harmful product or practice.
Many interested in ESG investing may also see ESG issues as a matter of moral values. With moral values as a consideration, those investors may not want their investment to aid business activities that contradict their given values. For example, an individual investor or institution may not want to invest in businesses that have no diversity on their board of directors because the individual or institution believes diversity in leadership is a key component to a successful business. The investor’s value has now driven their investment decision.
Regardless of one’s reason for ESG investing, it is crucial to know not only the benefits but also the risks.
Benefits of ESG Investing
ESG Investing Can Reflect Values
As previously mentioned, investors are focusing on sustainability and how they can align their investment decisions with their values of things such as preserving the environment or mitigating adverse climate effects. Data security, regulatory pressures, and a litany of other issues all present new risks for investors.v With ESG investing, investors may feel they have the best of two worlds: working towards their financial goals and doing so with a clear conscious.
Investing with an Organization’s Purpose in Mind
To qualify as a 501(c)(3) in the eyes of the IRS, an organization must have a charitable purpose.vi In the medical community, that could relate to improving any aspect of humanity’s well-being.
Given such a purpose, an organization’s board of directors or members may oppose the organization investing in companies that contradict its purpose. For example, a 501(c)(3) dedicated towards furthering people’s lung health may have members opposed to the organization having a portion of its reserve funds invested in tobacco companies. ESG investing allows the organization to satisfy the members’ values while still investing with the long-term in mind.
Positive Financial Performance
While historical data of ESG investing is limited, ESG investing has recently shown positive results from a financial standpoint. Some studies have shown that high ESG-rated businesses are more competitive and overperform, through measurements such as profitability and dividend payments, in comparison to low ESG-rated businesses.vii These studies have also indicated that high ESG-rated businesses also are less likely to experience major downturns in value and less volatility due to their ESG focus.
But why might this be the case? The argument is that by using ESG factors an investor will identify businesses that may be better managed. This better management is due to these businesses either explicitly focusing on ESG issues, or their practice and culture producing results that are ESG-friendly, which is then more likely to create more acceptable long-term performance. For example, ESG factors are suited to help identify businesses more likely to face adversity or growth issues due to changing regulatory, environmental, or technological trends.
Such positive performance theoretically makes sense. ESG considerations are important to any companies’ financial performance because ESG factors can include limiting costs, avoiding harmful incidents, and positioning for future sustainability. It should not be surprising that focusing on issues such as cost-cutting can lead to positive financial performance.
Risks of ESG Investing
What Exactly is Excluded?
Many investors use investment vehicles such as indexed mutual funds or ETFs because they capture broad markets’ returns while keeping internal expenses at a minimum. The rise of ESG funds has created the opportunity for ESG index funds – funds that track a respective index which excludes companies based on ESG factors.
With mutual funds or ETFs, overperformance and underperformance are always considered in comparison to how a relevant benchmark performed. Typically, either over or underperformance occurs because the investment vehicle allocates more or less to a given sector or security.
This is where some ESG investments run into issues.
Investors may assume they are removing just companies whose business activities are considered harmful to the environment or people’s well-being (i.e. tobacco, firearms, fossil fuels, etc.). But what may also be excluded could be hugely profitable sectors that the investor does not necessarily disagree with from an ESG factor standpoint.
A prime example is technology. ESG index fund underperformance has correlated to not owning enough technology businesses. One ESG index fund has lagged the S&P 500 by 35% over the past 10-year period and a reason why is that a prevalent stock the ESG index fund does not own is Amazon.viii So, while investors may expect they are investing in one set of criteria, they may actually be investing by a different criterion, or the criterion might exclude businesses the investor did not intend to have excluded. Given this potential over- or under-concentration in certain sectors, it is extremely important to understand the differences of available ESG funds across mutual fund and/or ETF companies and the indices they track.
A main concern from excluding certain companies is whether taking such an approach will compromise returns. After all, by excluding certain businesses or industries an investor will experience lower performance when excluded businesses or industries perform well financially.ix Essentially, by taking an ESG investing approach, these investors must be willing to forgo the potential superior returns of companies that have been excluded. Compromised returns by undertaking an ESG investment strategy could result in bigger problems as well.
For those serving on a board of directors, ESG investing can implicate issues regarding their fiduciary responsibilities as a board member. A board member has a fiduciary duty to put the best interest of an organization’s members first, whose benefits depend on the responsible management of assets. To meet this fiduciary duty when it comes to ESG investing, a board should consider the factors that may materially affect the organization’s investment performance.
ESG factors can be considered. They drive personal or organizational values and to ignore such values could pose a fiduciary liability risk. But to choose ESG factors and ignore their financial impact could pose fiduciary liability risk as well if the ESG factors are compromising returns.
Businesses’ Short-Term Focus
Another risk regarding ESG investing is that it may not fit well with some businesses’ short-term focus. Businesses’ leaders may be dealing with more critical or immediate issues, or they may be more focused on quarterly earnings and profits rather than placing their attention on the potential long–term value creation through ESG factors. ESG factors may not fit well with a short-term focus because they tend to affect financial performance over longer periods. For instance, the poor governance of a large company is more likely to affect the company over the long term than in the next quarter.x Although, if quarter after quarter a business does not focus on ESG factors, yet continues to outperform, then at some point the business’ long-term financial performance may still be successful even without the ESG focus.
Lack of data
A lack of information has often been a primary challenge when it comes to ESG investing. The lack of information relates to whether a business meets an ESG requirement and whether ESG securities provided acceptable returns.
For example, investors can consider ESG issues in their investment decisions only to the extent with which they have relevant information in a timely manner. Many businesses’ mandatory disclosures often provide limited information on ESG risks and opportunities.xi Further, the relevant disclosure(s) may be released before or after the usual financial statements. As a result, an ESG-focused investor may not have the necessary information to make an informed investment decision.
In addition, businesses that do disclose ESG-related information may have discretion in what they disclose. Businesses may disclose or exaggerate data that sheds a positive light on the business and fail to disclose data that does not benefit the business. This limits an investor’s ability to accurately choose securities based on ESG criteria.
Finally, financial performance data is relatively limited.xii Many investors seek to use index funds with an ESG focus. Such funds may only have existed for less than five or ten years. When it comes to weighing historical performance, long-term performance results are a crucial factor. Without adequate historical performance to work with, it may be uncertain whether the investment strategy truly works with the long-term in mind.
ESG investing has changed the entire investment landscape. ESG factors are becoming more and more important, especially as younger generations participate more heavily in investment markets. ESG investing presents a great opportunity to align one’s values with economic growth. But like any other investment, this reward comes with risks. To best understand these risks requires as much information as possible, which may be difficult to find.
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Investment Advisory services offered through MEDIQUS Asset Advisors, Inc. Securities offered through Ausdal Financial Partners, Inc. 5187 Utica Ridge Road, Davenport, IA 52807 (563)326-2064. Member: FINRA/SIPC. MEDIQUS Asset Advisors, Inc. and Ausdal Financial Partners are independently owned and operated. Investments are not FDIC-insured and are not deposits of or guaranteed by a bank. The material has been prepared or distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.