ESG Investing: A Beginner’s Guide

In the past decade, companies have been forced to shape their practices amid growing concerns from the public about how they have been impacting many aspects that are relevant to the progress of society such as the environment, working conditions, privacy, and gender equality.

On the back of these growing concerns and activism, a new investing methodology has emerged to track businesses that are improving in these areas rapidly. This trend is known as ESG investing.

What Is ESG Investing?

The acronym ESG stands for environmental, social, and governance. These are the areas this investing methodology focuses on. The environmental side of this trend focuses on how businesses are working to reduce the negative impact they have on the ecosystem by reducing pollution, deforestation, and damage to the fauna.

Meanwhile, the social side of ESG investing is focused on how companies deal with the impact they have on society and human behavior by implementing policies that affect diversity, privacy protection, human rights, and labor conditions.

Finally, governance deals with corporate structures and their alignment to what is considered healthy principles such as transparency, fairness, and legality. These principles are expected to be upheld through the implementation of sound corporate governance schemes and by regulating executive compensation and political influence to the extent that it does not harm society.

One interesting landmark that could have set in motion the chain of events that brought ESG investing to where it is now was a decision from ExxonMobil’s shareholders in 2017 that pushed for the creation of a report about the impact that the company had on the environment.

The decision came roughly a year after the Paris Climate Accord was signed and possibly sounded the alarm for senior managers and investors about how organized groups of shareholders could make a difference when it comes to pushing companies to adopt more ESG-friendly policies.

Note: ESG criteria is used by investors to analyze companies and assess how these corporations compare to their peers in terms of performance when considering environmental, social, and governance factors alongside financial factors.

How ESG Investing Works

In essence, ESG investing focuses on finding companies whose policies and actions contribute to improving aspects that belong to the three areas outlined above. 

Investors who support this method believe that these companies are poised to generate higher returns over time as people will increasingly favor ESG-conscious companies due to their positive contribution to mankind’s advancement.

Environmental

The environmental side of ESG investing analyzes how the company is planning to reduce its carbon emissions, pollution, and any other negative impact that its operations could have on the environment.

In this regard, many companies have established targets for becoming net-zero emitters as is the case of United Airlines, an American airline that has set the goal of becoming 100% green by 2050.

Meanwhile, there are other major fronts that companies also have to deal with to be considered eco-friendly including any measures implemented in the fields of energy consumption, water recycling, and waste management.

Social

The social aspect of ESG investing dives into how a company adopts policies that benefit different corners of society, including its workers, the community, and the public in general.

One prominent topic among social agendas is gender equality, which aims to eliminate the gap that has existed for years between the salaries earned by men and women in corporations. Moreover, gender equality also seeks to increase the share of female executives that participate in the board of directors of the world’s largest corporations as they also play an important role in shaping the corporate world.

Finally, with the rise of technology, privacy concerns, and data sharing practices have also taken a lead role in social agendas and ESG-friendly companies are expected to take decisive steps to deal with these issues in a way that benefits society as a whole.

Governance

Finally, analyzing a company’s corporate governance practice involves understanding how its top executives are compensated compared to the rest of the workers and how the company prevents and corrects misconducts and acts of corruption. This approach  also takes a look at the political influence that corporations have by analyzing their lobbying efforts.

How to Get Started with ESG Investing

Research companies and financial services firms have made ESG investing for layman investors by creating specialized investment vehicles.

Meanwhile, some of these companies have developed scores through which investors can identify the most ESG-friendly stocks, such as the MSCI ESG Ratings and the Fitch Ratings ESG Scores.

Step 1: Open a Brokerage Account 

There are two ways to build an ESG-focused portfolio but the first step to getting started on both is the same: opening a brokerage account.

That said, different brokers offer different ways to access ESG products as you can either follow a do-it-yourself (DIY) approach, which involves picking the instruments you will be incorporating into your ESG-focused portfolio by yourself, or you could let an advisor (including robo advisors) pick them for you.

Option 1. The DYI Approach

Most brokerage firms in the United States nowadays offer access to zero-commission trading services for US-listed exchange-traded funds. This allows investors to build a portfolio of ESG-focused ETFs such as the iShares ESG Aware MSCI USA ETF (ESGU:NASDAQ), which has an MSCI ESG Fund Rating of A while currently charging a 0.15% annual expense ratio.

Keep in mind that it will probably take you some time to research and select the right ESG ETFs and mutual funds.

Option 2. Let Someone Else Build an ESG-Focused Portfolio for You

This second option is often the most comfortable for part-time investors as it will remove the often time-consuming task of having to pick among the vast universe of ESG-focused instruments out there.

If you are going to take this road, you could either sign up with a robo-advisor that offers an ESG-focused portfolio such as Betterment and Ally Invest or you could rely on the services of a human advisor.

The downside would be that these advisors charge a fee for providing their services. However, competition has reduced the cost of accessing an advisor to a point that the benefits usually outweigh the cost.

Step 2: Understand ESG Policies

One thing that ESG beginners should understand is that there is no single approach to ESG investing that fits everybody’s criteria and preferences. Instead, most investors should focus on areas of ESG that are the most important for them. They can build up their portfolio based on the kind of improvements they would like to see by choosing companies that are currently making the most progress on those particular fronts.

For example, if you are a strong advocate of gender diversity and equality in corporate governance you could lean toward investing in companies that have advanced a fair deal in this particular area.

Moreover, if you are a big supporter of a shift toward renewable sources of energy you can invest in businesses that are developing the kind of technology that can disrupt the way the world works at the moment.

Therefore, you should first define the kind of principles and trends you would like to invest in. Then, you can move on to identify the best companies out there making progress on these fronts.

Step 3: Find ESG Investment Opportunities

There are many instruments that investors can incorporate nowadays to build an ESG-focused portfolio, the first one being individual stocks. 

If a particular company has attracted your interest due to its ESG-friendly practices, you can analyze the business to see if their financial performance is attractive enough to justify their valuation and you can also analyze how friendly they are to ESG-focused practices by researching their ESG scores.

MSCI has developed a mobile app through which you can browse the ESG scores of more than 2,800 companies from around the world.

Moreover, if you have an exchange-traded fund (ETF) you would like to invest, in you can also track their ESG score by using websites such as ETF Database and ETF.com or you could build a diversified portfolio of ESG-focused companies by using ETFs that invest in businesses with the highest ESG scores.

Two prominent examples of high-score ETFs are Vanguard’s ESG International Stock ETF (VSGX:BATS) — a pure-play ESG ETF — or the iShares Semiconductors ETF (SOXX:NASDAQ), which has an ESG rating of AAA with a score of 8.6 out of 10.

However, keep in mind that the best ESG-focused funds and instruments for you will be those that are aligned with your ESG-related interests.

Here are a few examples of ESG ETFs and mutual funds worth exploring:

Difference Between ESG, SRI, and Impact Investing

Even though there are multiple similarities between these three investing methodologies, there are also slight differences that are relevant enough to justify the need for three separate concepts.

Socially Responsible Investing

Socially responsible investing is a subset of ESG investing and it focuses on seeking opportunities that generate a net positive impact on environmental and social issues. Different from ESG, the criteria used to decide if an investment can be considered as “socially responsible” is mostly financial rather than qualitative.

Impact Investing

Impact investing seeks to alter or disrupt a social or environmental reality by allocating money to initiatives that can achieve this goal. Different from ESG, impact investing focuses on how the money that will be poured into the company will contribute to change a specific situation rather than focusing on the internal processes and practices followed by the company.

Benefits of ESG Investing (Pros)

• ESG investing is widely accessible for retail investors nowadays through vehicles such as exchange-traded funds (ETF) and mutual funds.
• This methodology is rewarding beyond a monetary standpoint as there is a net positive contribution to society.
• Investors can shape how society functions by funding the companies that are the most aligned with their environmental and social views.
• ESG-focused investment vehicles tend to charge low expense ratios compared to other actively managed vehicles.
• ESG scores and other similar tools have helped investors easily screen the most ESG-friendly companies.

Downsides of ESG Investing (Cons)

• ESG-focused stocks will not necessarily outperform the market.
• ESG scores might not capture the reality of a business’ practices as they focus more on what the numbers indicate rather than the actual impact.
• The criteria to define an ESG-focused strategy varies widely from one investor to the other which opens up the possibility for ample performance gaps from one actively managed fund to the other.

Pro Tip: A well though-out ESG investing strategy can reduce portfolio risk and generate competitive investment returns.

FAQ ESG Investing

The following are answers to the most frequently asked questions we get about the topic of ESG investing.

Is ESG Investing Good?

ESG investing is just another investment methodology like value investing or theme investing, which means that assessing how “good” it is, depends on each investor’s individual views and preferences. 

However, this kind of investment carries the added value of a positive impact on society. It helps improve the policies and practices adopted by corporations with regards to relevant issues that shape our world.

What Are Good ESG Investments?

All investors define what a “good” ESG investment is on an individual basis. However, performance should always triumph. 

Therefore, a good ESG investment should deliver both a positive performance and a net positive impact on environmental, social, and corporate governance matters.

How Is an ESG Rating Calculated?

ESG ratings, such as the ones provided by MSCI, are calculated by analyzing multiple variables related to the three focal points of ESG including climate change, use of natural resources, pollution and waste, corporate governance, corporate behavior, human capital, and relationship with the community.

Each of these variables is assigned with an individual weight based on their relevance and corporations get a score ranging from one to 10 for each of these characteristics. The overall result is the sum of all weighted scores.

What Are Good ESG Funds?

Same as with the criteria outlined above for defining a “good” ESG investment, a good ESG-focused ETF should deliver both solid gains for investors while maintaining a strong focus on its core ESG strategy. Moreover, annual fees should also be considered since an expensive ETF could eat up most of the gains that investors will realize by following this approach.

Can ESG Investing Reduce Portfolio Risk?

Since the definition of ESG investing can vary from one investor to the other, the exact contribution that a basket of ESG-focused stocks or instruments can have on mitigating a portfolio’s risk is quite difficult to estimate.

However, it is important to note that due to the increased importance that corporate governance and social matters have for ESG-friendly companies, these businesses should tend to obtain better credit ratings when compared with how they would be assessed if one removes the ESG-related improvements.

Can ESG Investing Provide Higher Portfolio Returns?

A paper from JP Morgan Asset Management published in March 2021 found that ESG-focused stocks tend to generate higher returns on equity and lower earnings volatility due to the “good management” component that comes with healthy corporate governance practices.

Final Thoughts

Given the wide scope and reach that the acronym ESG has, this brief guide should serve as a starting point for you to keep researching this interesting methodology. This way, you can design a system that allows you to identify the companies that better suit your particular ESG-related criteria.

We hope you find some world-changing companies out there once you start diving into the fascinating world of corporate practices. Good luck!

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