Editor’s note: This column is part of InvestorPlace.com’s Ultimate Guide to ESG Investing.
What do the wildfires in California, corporate board diversity, plant-based burgers and employee compensation have in common? All are aspects of environmental, social and governance (ESG) investing, a portfolio method that combines financial returns with concern for the world around us.
Like all acronyms, ESG investing can be a bit confusing. It means different things to different people, and there is no one-size-fits-all approach. However, what you do need to know is that it is only gaining in popularity and profitability right now.
As we will further explore, Wall Street has come a long way when it comes to this trend. Once a fringe concept reserved for hippy-dippy investors, ESG strategies are now mainstream. Electric vehicles. Solar power. Plant-based diets. Sustainable retail. All are trends in their own right, and they are booming alongside what some see as an ESG megatrend.
Underneath it all is the reality that, now more than ever, you can profit while investing with your heart.
Not only can you align your portfolio with your values, you can use the stocks and funds you pick to create the future you want. Like the way that sounds? It turns out that a whole lot of investors do. Let’s dive in to ESG investing now.
What Is ESG Investing?
A good place to start is the acronym itself.
- E is for environmental. Broadly, this component of ESG investing requires individuals to evaluate what impact a company has on the environment. On one hand, you can opt to support companies that help the planet, like electric car makers and plant-based meat suppliers. On the other hand, you can choose to exclude companies contributing to pollution and animal extinction. These “bad” companies can include mining names and fossil fuel firms.
- S is for social. When you think social, think of people. Companies that excel at this component of ESG investing are doing right by their customers, employees and the general public. This has become particularly important as social justice movements like Black Lives Matter grow in mainstream visibility and acceptance.
- G is for corporate governance. The third component is where ESG investing can get a bit technical. Here, investors are considering how well a company treats its shareholders, who sits in the C-Suite and on the board of directors, and what decisions company leadership makes. Perhaps one of the most topical issues within this component is board diversity — a notion that the gender and racial makeup of a board matters to shareholders, the public and even overall stock returns.
The bottom line is that this acronym incorporates a whole lot — and you do not have to check every box with one investment. Instead, there are a variety of strategies that allow you to consider the environment, society and corporate governance as you choose stocks and funds.
Why It Matters Right Now
Before we dive into the nitty-gritty history and all of the different ways you can approach ESG investing, it is important to understand why it matters right now.
Put simply, investors care about profits. While it sounds nice to care about the environment, many individual investors have financial returns as a top portfolio priority. That is why recent outperformance by ESG stocks and funds is so important. As InvestorPlace analyst Neil George highlighted recently, over the trailing 10 years, the S&P 500 ESG index has returned more than 210%. In just the last year, that same index has outperformed the general S&P 500 by almost 20%.
In other words, investing with ESG factors in mind may very well be better for your portfolio.
As this performance continues to improve, the ESG acronym is also being aided by a variety of current events. Wildfires in California and Australia have raised interest in the reality of climate change — and what consumers, companies and governments need to do to slow down its harmful effects. The Black Lives Matter movement, along with other calls for social justice, have raised awareness in what each company is doing to make the world a more equitable place.
Lastly, the novel coronavirus is also challenging investors to think critically about their individual impact. As a result, the environment and sustainability matter more in decisions than ever before.
A Long Evolution of Values-Based Investing
So where does this ESG acronym come from? At one point in time, Wall Street turned its back on anyone who dared to focus on anything but shareholder value. As Alyce Lomax and John Rotonti wrote for The Motley Fool, that is not necessarily a problem in itself. However, investors need to consider what a company is sacrificing in order to focus solely on profits. For instance, is it paying its employees a fair wage? If not, it could be worsening social unrest by contributing to income inequality, jeopardizing the ability of the corporate world to keep humming.
Along the way, different groups started to recognize this. Some historians point to the Quakers as the originators of values-based investing. Why? In 1758, the religious group banned its members from financially supporting the slave trade.
While the Quakers may have been some of the first to marry money with morals, modern-day responsible investing really got a start in the early 1970s. In 1971, Luther Tyson and Jack Corbett launched Pax Sustainable Allocation (MUTF:PAXWX). The duo wanted to keep investment dollars from flowing into the Vietnam War, raising shareholder concerns over the use of chemical weapons like Agent Orange.
Then, just a few years later, Wall Street saw new issues generate awareness. The Exxon Valdez oil spill mobilized many investors to oppose fossil fuels. Apartheid in South Africa also concerned U.S. investors, leading Congress to pass the Comprehensive Anti-Apartheid Act. This bill banned new investments in the nation, and also saw firm Calvert become the first to sponsor a shareholder resolution on a social issue.
In the decades since, these issues of justice and the environment have continued to play out. New indices, sustainable funds and even recommendations from the United Nations have shaped and shifted ESG investing.
The BlackRock Letter and ESG Investing in 2020
So how have things changed since the days of apartheid and the Vietnam War?
While Wall Street certainly got mainstream exposure to the idea of socially responsible investing (SRI) in the 1970s, it was not exactly identical to what we consider ESG investing.
Then, investors cared about excluding harmful companies. Now, ESG investing encourages investors to include companies with stock purchases. Although it can still incorporate moves away from problematic equities — such as gun, pharmaceutical and oil stocks — investors use a variety of strategies to actually load up their portfolios with so-called ESG stocks and funds. These world-conscious portfolios are intended to outperform the S&P 500, or at least be profitable while making a difference.
This shift to inclusion takes us to the present day — and has helped attract new supporters. As Blake Pontius, the director of sustainable investing for William Blair, put it, a new focus on inclusion makes ESG investing more exciting. Millennials can back the companies they care about, like Beyond Meat (NASDAQ:BYND) and Nike (NYSE:NKE). This makes it more approachable and underscores just how much growth is involved.
Beyond this big shift, the other major catalyst that has informed ESG investing in 2020 is an infamous shareholder letter from BlackRock (NYSE:BLK) CEO Larry Fink. As the leader of one of the most influential fund companies, what Fink says matters. He called for a “fundamental reshaping of finance” that recognizes the responsibility Wall Street has to take care of the planet. Importantly, he also promised that BlackRock would start making decisions with things like climate change in mind.
Since then, ESG investing has hit several major milestones. Just recently, related index funds hit $250 billion in assets.
How Do You Pick ESG Stocks and Funds?
Clearly, there is a lot to consider with ESG investing. That is why Adam Coons, a portfolio manager with Winthrop Capital Management, told InvestorPlace that there is not a one-size-fits-all solution. Instead, he says:
In a world of increasing social and economic unrest, what is important to one investor may differ widely from another. ESG investing is meant to allow people to invest according to their values. … [W]e believe the only way to provide true ESG portfolios to investors is through individual customized solutions.
As you are thinking about your custom approach, know that you have a lot of options. You have both technical guidelines like ESG scores and your fundamental preferences.
As ESG investing grows in popularity, so too do so-called ESG scores. These figures are essentially grades that measure how a company complies — or doesn’t — with each component of the acronym. Refinitiv takes the former approach, focusing on how well each company performs when it comes to ESG. Sustainalytics takes the latter approach, assigning each company a risk score. With just two firms, you have two different methodologies.
Instead of focusing on grades, you can choose to pursue specific areas of ESG. You can pick stocks of companies that have women as CEOs, or stocks that are particularly kind to the environment. If your biggest concern is fighting climate change, there are ways to target your investments to do just that.
Robert Johnson, a finance professor at Creighton University’s Heider College of Business, recommends using ESG ETFs:
While individual investors can screen companies on their own to create a portfolio that will allow them to do both good socially and well financially, such a strategy is difficult and risky to implement. … Trying to pick winners, for most, is a loser’s game. The solution is to invest in diversified funds and [then] you don’t need to pick those winners.
The Challenges With ESG Investing
There are two big challenges that currently plague ESG investing. As Stuart Estate Planning Wealth Advisors President Craig Kirsner told InvestorPlace, the first problem is that the vocabulary is confusing. He says:
The challenge is that ESG investing remains a bit ambiguous. When trying to analyze a mutual fund or ETF it’s easy to get confused by the many climate-related terms such as green funds, low emission, low carbon, fossil fuel free, clean energy, and renewable energy, just to name a few.
The other issue is that so much is up to personal interpretation. Your personal values may call you to avoid stocks of defense companies, but they may score high on ESG rubrics for employee compensation or for having a diverse board of directors. Does that mean you should ignore your antiwar values and buy those defense stocks? Not necessarily. It all comes down to what you hope to get out of ESG investing.
Tesla (NASDAQ:TSLA) is another great example of this. As a leader in the electric vehicle space, the wellbeing of the planet is at the core of its mission. At the same time, the company has come under fire for its alleged mistreatment of employees, and for its supply chain. If your priority in ESG is the environment, Tesla stock could very well find its way into your portfolio. If not, you may pass this red-hot name on by.
Perhaps as ESG investing continues to grow in influence and popularity, we will see more concerted efforts to resolve these problems. A streamlined vocabulary or a single dominant approach could make it more accessible to new investors.
The Bottom Line
At this moment in time, there is no shortage of money or interest flowing into ESG investing. Thanks to megatrends like electric cars and the impact of the coronavirus, this is likely to remain true — and accelerate — for some time to come.
For investors, that means it is time to start paying close attention. Lining your money up with your values is a great way to ensure portfolio success.
On the date of publication, Sarah Smith did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Sarah Smith is a Web Content Producer for InvestorPlace.com.