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What is ESG investing?

“ESG” stands for three factors fundamental to corporate accountability and sustainable performance: environmental, social and governance. There’s a whole industry that tracks and analyzes how well companies do on ESG factors, with the aim of informing investors who might want to buy assets that align with their personal values.

If you typically read the list of ingredients on the back of food packages, you already know how to approach ESG investing.

“ESG” stands for three factors fundamental to corporate accountability and sustainable performance: environmental, social and governance. There’s a whole industry that tracks and analyzes how well companies do on ESG factors, with the aim of informing investors who might want to buy assets that align with their personal values.

But analysts and advisors said that putting your money where your values are is more complicated than buying into funds and stocks that wear the ESG label. You’ll have to learn about the factors that resulted in those ESG scores and then figure out how those investments support your financial goals.

How does ESG investing work?

ESG investing is more about data than politics or personal values, explained Susie Wang, director of the investment strategy team with wealth management firm Balentine.

“ESG is one way to assess how companies manage risks and opportunities. It’s not your personal values as much as it’s about data that analysts use to measure companies’ ability to manage anticipated future changes,” she said. Just as any one food may or may not be a good pick depending on your dietary and health goals, any one highly-rated ESG stock or fund might or might not support your investment horizon and the financial return you need to achieve those goals, Wang explained.

“You have to think holistically. If you like a company, do your homework, and understand what are the specific impacts that this company is making. Then you can think about this investment, as one of the many in your portfolio,” she said. “Think about the actions that you’d like to support — and realize that every company and fund will present a mixed picture.”

For example, some companies centered around fossil fuels are also major investors in green energy. A strict ESG lens focused on environmental factors might exclude them based on current operations, but a view that prioritizes sustainable energy might include them because they also are building energy sources for the long run.

ESG investing versus socially responsible investing (SRI) versus impact investing.

ESG factors are generally considered to apply to companies’ current operations, explained Tracy Barba, director of venture and equity ethics at the Markkula Center for Applied Ethics at Santa Clara University.

The “socially responsible” investment philosophy is more sweeping and aims to encourage companies to think about big-picture impacts of aggregate decisions.

“Impact investing” said Barba, “drives change and doesn’t just reward change. You’re thinking through the potential outcomes of the investment.”

StrategyFocus
ESG investingExamines how ESG factors pose risks and create opportunities for companies in order to maximize returns
Socially responsible investingPromotes investing based on one’s ethics and values rather than focusing on returns
Impact investingFocuses on making investments to advance social and environmental causes while still generating positive returns

Steps to start ESG investing

It’s a big universe, so start with what’s already in your portfolio, advised Michael Young, director of education and outreach for US SIF, the Sustainable Investment Forum. The forum works with companies to focus on sustainable, long-term investment that integrate “positive social and environmental impacts.”

Wade into ESG by first collecting the stock or fund symbols for the holdings in your retirement accounts and investment portfolios. Then, recommended Young, run those symbols through the Invest Your Values assessment tool at As You Sow, a nonprofit that provides consumer-friendly snapshots of ESG rankings and data.

The As You Sow tool helps you “figure out what you have,” said Young. “You’ll know if a fund has a certain amount in private prisons, say, or weapons of war, gender equity, deforestation, you name it.”

Once you can view the ESG factors in your portfolio, you can line them up with your own priorities. Bearing in mind that ESG investing involves a lot of trade-offs, you can identify investments that both achieve your financial goals and that at least somewhat reflect your personal priorities.

How are ESG scores calculated?

“These ratings are most useful for professional investors, who use the data to build investment models,” said Young. If you want to put a fund under the ESG microscope, use tools at Morningstar, a fund analysis firm, to see how its analysts weight different factors to arrive at various ESG scores.

While the calculations that go into figuring ESG scores are quite involved and vary by provider, Morningstar uses a two-step process to determine a fund’s Sustainability Rating. First, it calculates a “Portfolio Sustainability Score” that measures how companies within the fund are managing ESG risks and opportunities. It then measures that score relative to a fund’s category peers to determine its Morningstar Sustainability Rating.

But, said Barba, remember that “ratings systems are based on self-disclosed information and what’s been deemed to be financially material.” Company disclosures may not tell the whole story and, thus, ratings may be based on incomplete data.

Choosing your ESG investments

Advisors and analysts stressed that nearly every company and fund represents a mixed ESG bag. Technology companies, for instance, might offer strong, consistent financial growth; appear to make sound environmental choices; and invest in products that might improve human well-being — all with a disproportionate number of white, male engineers and leaders, largely cutting minorities and women out of career and economic growth opportunities.

One way to consider ESG factors is to look at small, measurable steps that companies take on values that are important to you. Through annual reports — financial, ESG and diversity — available at the websites of publicly held companies, you can see specific steps that companies take and then decide if those steps merit the company a place in your portfolio.

Pros and cons of ESG investing

Exploring ESG factors is a good entrée to investing strategies overall, advisors and analysts say, especially as you trace the effect of ESG-linked decisions with financial results, and vice versa.

But investors sometimes err by taking a hard line about some industries that could also make their portfolios vulnerable, said Wang. When scorned industries do well, they don’t lift the results for a portfolio that doesn’t include them. That’s especially important for major categories, like consumer goods and energy, Wang said, that are embedded in many financial performance indices and sectors.

“If you accept that, then you have to realign the financial return you will get and how that supports your financial horizon and goals,” she said.

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