ESG Investing: Doing Well by Doing Good

​Many folks have mixed feelings about investing. On the one hand, they know that investing in stocks or mutual funds may be the best way for them to finance a comfortable retirement or put their kids through college. But on the other hand, they might not feel all that great about some of the companies their investment dollars support.

Maybe they've read that a particular clothing manufacturer employs child labor in unsafe factories in some far-off corner of the world. Perhaps another company produces high levels of toxic waste. Another might be less than forthcoming in the way they report their profits. Our hypothetical investor might wish to avoid investing in the stocks of those particular companies.

On the flip side of the coin, this investor might have a desire to actively support other companies, such as those involved in producing clean energy or whose board of directors includes a high proportion of women and minorities.

Over the last few years, more and more investors have become vocal about seeking such options, and a market has arisen to meet the demand. The phenomenon is known as ESG investing. 

"ESG" stands for environmental, social, and governance. In a nutshell, this approach tries to avoid investing in companies deemed to have a negative impact in those three areas, and favors companies that try to make the world cleaner, kinder, more diverse, and more sustainable. Here's a quick look at each factor:

The Environmental area deals with sustainability. It considers such factors as air and water quality, clean energy, natural resource conservation, waste management, and hazardous materials.

The Social area deals with humanity. It looks at labor practices, health care, education, housing, and community involvement.

The Governance area deals with corporate ethics. It examines pay equity, executive suite diversity, shareholders' rights, accounting transparency, and the makeup of companies' boards.

As you can imagine, this is a new and rather loosely defined discipline. There are no hard and fast rules defining what does and does not qualify, so you need to look carefully at the options—and there are a lot of them.

The most common way to participate in ESG is through a mutual fund or ETF (exchange-traded fund). The differences and similarities of mutual funds and ETFs are not important to this discussion, so we’ll set them aside for now and concentrate on the ESG filters.

Consider a hypothetical ESG-focused mutual fund. It might be exclusionary, meaning it filters out companies it considers to be especially egregious in certain ESG areas—or it might be inclusionary, meaning it actively seeks to identify and include companies that are leading the way in a respective ESG discipline. It may focus on only one factor—environmental, for instance—or incorporate all three.

Even though ESG investing is a relatively new strategy, hundreds of mutual funds and ETFs utilize its principles to some extent or other. More ESG vehicles are popping up all the time. But like all strategies, there are some limitations and special considerations.

Most of the concerns arise from the newness of the concept. Definitions of what constitutes ESG investing are not always consistent among fund managers, which can lead to considerably different approaches. Rapid growth in the ESG space has led to a plethora of options, many of which have a small asset base and a short or nonexistent trach record. 

Then there’s the diversification issue. Most investors diversify as a way to reduce market risk: they buy lots of different companies in lots of different industries. But ESG funds purposely limit the list of companies in which they invest, which can potentially decrease diversification and lead to a dilemma for investors who want both diversification and ESG filters. 

In other words, as with any area of investing, look closely and learn as much as you can before committing your hard-earned money. 


 
This column is not intended as advice but rather education, commentary and opinion. Consult a professional advisor. If you have general questions about financial planning or investments, feel free to submit them to Andy at [email protected].