Takeaways
- Environmental, Social, and Governance investing prioritizes a set of core values.
- ESG investing is designed to invest in sustainable companies that uphold ethical practices.
- ESG investing is designed to invest in sustainable companies that uphold ethical practices.
- ESG-focused investing can mitigate investing in companies that are unaligned with your values.
- Major investment advisors like Fidelity, Blackrock, Vanguard, and Charles Schwab have ESG-focused fund managers.
What Is ESG?
Environmental, social, and governance (ESG) is a framework used by investors and companies to gauge their level of sustainability. ESG investing was born from a movement in the 1950s that advocated for companies to focus on more than profits alone. Instead, investors advocated for companies to merge their corporate goals with sustainability efforts.
As a result of this movement, ESG became more of a formalized discussion among investors, the board of directors, and company executives. In 2011, the Suitability Accounting Standards Board (SASB) was founded to create accounting rules to reflect ESG impacts on a business.[1] This significantly affected sustainability discussions for publicly traded companies that have stock traded on the major stock markets by retail investors and institutional investors focused on ESG measures.
With investor attention and demand skyrocketing, large investment firms created ESG indexes and mutual funds. According to Bloomberg Intelligence forecasts, the global ESG asset market is projected to eclipse $40 trillion by 2030.[2]
With ESG as a common investment criterion for many investors, it is commonplace for investors to assess an investment opportunity through the lens of ESG. For example, investors analyze a company’s financial and business trajectory, while also considering the company’s sustainability impact. Companies that don’t achieve high marks in all categories are culled from investment portfolios.
ESG investing frameworks work to quickly identify and prioritize companies performing well financially and making the world a better place. To do this, the positive contributions companies make to the environment and society must be quantifiable for investors. Let’s dive deeper into the ins and outs of ESG investing.
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How ESG Investing Works
At its core, ESG investing works by factoring in environmental, social, and governance elements during the investment analysis and investment decision-making process.[3] Investors use ESG criteria to assess their investment options and select companies that meet specified sustainability and ethical standards.
Investors can use positive screening, choosing companies with strong ESG performance, or negative screening, which excludes entities with unsatisfactory ESG metrics.
Much of the ESG data that investment managers and analysts use is publicly available, while other data consists of third-party ratings or even proprietary research. ESG reports involve analyzing a company’s carbon footprint, labor policies, diversity and inclusion policies, and board composition.
ESG investing is not just limited to investing in specific companies or stocks. The ESG criteria can be used to evaluate a range of industries and asset classes, including stocks, bonds, and managed funds. By using ESG data wisely, investors can build effective, diversified portfolios that align with their financial goals while also helping to develop a more positive environmental and social landscape.
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Advantages of ESG Investing
For many ESG investors, socially responsible investing is a reward unto itself. However, there are many benefits beyond curating a sustainable portfolio. Here are several pros to consider:
- Higher Return Potential: Depending on the year, macroeconomic conditions, and ESG adoption by industry, the returns on ESG stocks, mutual funds, and ETFs could outperform traditional funds. According to a recent Morningstar report, in 2023, ESG funds trailed traditional funds but recovered those returns in 2023.[4] While some ESG funds outperformed traditional funds, there is room for improvement and higher returns. Performance could improve over time as more companies adopt and streamline ESG measures.
- Management Style: By focusing on ESG measures, an executive team can remove the short-term nature of business cycles and instead focus on building long-term shareholder value. This might mean positioning the company with more robust ESG policies now, which leads to better products, satisfied customers, and higher investment returns. With a more sustainable business model, operations can be streamlined to reduce redundancies and costs. Companies with an ESG focus are also attuned to regulatory and environmental shifts.
- Risk Mitigation: Another considerable benefit is risk mitigation, which results from risks that are highlighted during ESG rating and are more likely to be overlooked by traditional analyses. For instance, a company with poor environmental scores may be more apt to face regulatory and legal fines or damage to its professional brand. Damaging a company's long-term prospects can cost investors in the long run and could be prevented with a practical ESG framework.
- Positive Change: ESG investing can drive more positive change. By directing capital towards companies with stronger ESG scores, investors can quite literally “vote with their dollars” for companies that work harder to improve in the modern world.
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Disadvantages of ESG Investing
Even though there are significant advantages to ESG investing, it is also critical to highlight the cons. Here are several disadvantages to consider:
- Lack of Standardization: One of the biggest challenges for ESG investors is the need for more standardization among ESG reporting frameworks. For example, there is the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), United Nations Global Compact (UNGS), and Task Force on Climate-Related Financial Disclosures (TCFD).[5] Since there are various rating agencies, one assessment is only sometimes easily comparable to another.
- Investment Risk: Another notable con of ESG investing is that limiting your investments to solely ESG-focused assets can limit or even decrease investment diversification. ESG investing often involves wholesale, excluding specific industries or companies that do not have appropriate ESG ratings. Excluding investment options can limit your investment landscape, leading to higher portfolio risk.
- Financial Tradeoffs: A lesser-known disadvantage of ESG investing is the possibility of performance tradeoffs. Even though many ESG companies can perform well, implementing ESG measures comes at a cost. The cost of implementing ESG could distract management from its core business focus and take time to percolate throughout business practices. For short-term investors and stock traders, absorbing the costs and potential lack of investment return might harm your portfolio.
- Greenwashing: There is also the risk of “greenwashing,” which is the practice of embellishing or lying about a company’s ESG practices to make it look better on paper.[6] Greenwashing is done to specifically mislead investors. As with all investments, extensive research is vital before making any stock purchase.
Where to Invest in ESG Companies?
Whether you are an accredited investor or a beginner investor, investing in ESG investments can be done in various ways. Here are two popular avenues to consider:
ESG Individual Stocks
ESG investments in individual stocks mean you are investing in specific companies that have shown strong performance in their governance, social, and environmental criteria. Investing in individual ESG stocks will require research, but most online stock brokerage accounts offer free resources.
Investors will be able to identify ESG stocks through ESG ratings and research reports. These agencies evaluate companies based on specified ESG factors, which helps standardize evaluation. Standardization makes it easier for investors to invest directly and support companies aligned closely with their values. Additionally, a financially well-performing ESG company can boost your net worth over time.
ESG Mutual Funds
Portfolio managers manage ESG mutual funds. Mutual funds pool money from multiple investors to invest in a diversified mix of companies that have achieved specific ESG criteria. Professional portfolio managers manage these funds and select investments based on deep ESG analysis. ESG mutual funds are perfect if you are looking for an accessible way to diversify your investment, include sustainable investing in your portfolio, and avoid having to pick a single stock to invest. (Read more about mutual funds.)
Investors can invest in ESG mutual funds that cover several sectors or industries to lower risk. You can also align your investments easily with their personal values and support more proactive companies in prioritizing sustainability, social responsibility, and ethical governance
Smart Summary
If you relish the idea of trying to make your dollars count toward making companies more sustainable, ESG investing might be for you. As the focus and boom of this investing class evolves, so will ESG framework standardization. Over time, this should make it easier to pick the ESG winners and shed the losers. Whether you want to dive into ESG or not, it is something all investors should pay attention to. Review your investments to see if investing in an ESG stock, mutual fund, or ETF makes sense for you and your money.
(1) SASB. The evolution of SASB Standards. Last Accessed January 15, 2025.
(2) Bloomberg. Global ESG assets predicted to hit $40 trillion by 2030, despite challenging environment, forecasts Bloomberg Intelligence. Last Accessed January 15, 2025.
(3) U.S. Securities and Exchange Commission. Environmental, Social and Governance (ESG) Investing. Last Accessed January 15, 2025.
(4) ESG Fund Returns Recover, but Still Trail Conventional Peers by a Small Margin. Last Accessed January 15, 2025.
(5) Bloomberg Law. Comparison of ESH Reporting Frameworks. Last Accessed January 7, 2025.
(6) Investor.gov. Greenwashing. Last Accessed January 7, 2025.
