What is ESG investing, and is it right for you?

Investing can help you build wealth and save for retirement, but selecting individual stocks to invest in is time-consuming and risky. Picking the wrong stock can lead to a dramatic loss in your investment — and if you’re investing money you need (say, for retirement or a down payment on a home), that can have a traumatic impact on your finances.

That’s why many people invest in managed funds. Managed funds pool your money with those of other investors and use it to purchase assets, such as stocks and bonds. Since they diversify the risk of your investment across numerous assets, there’s less chance you’ll experience the volatility that investing in a single company can bring.

However, when you invest in a managed fund, you can’t select the fund’s assets yourself. If you have strong beliefs about certain activities, such as pollution or labor violations, you may unwittingly support companies that regularly violate your values.

To better align their beliefs and investing practices, some people turn to ESG investing. In this article, we’ll discuss what you need to know about ESG investing so you can determine whether it’s right for you.

What is ESG investing?

The term ESG stands for environmental, social, and corporate governance. Each element of ESG describes how a company impacts society through its environmental, social, and corporate governance policies.

Environmental

Some companies strive to protect the environment through their business strategies. They may have a strong stance against activities that adversely impact climate change, or promise to engage in proper practices around recycling and material sourcing.

A few examples of environmental factors within a company’s control include:

• Use of green products or technologies
• Carbon footprint
• Policies concerning climate change
• Usage of renewable energy vs fossil fuels
• Recycling activities
• Promotion of public transportation and carpooling

Typically, companies will publicly note their commitment to the environment through their website or other channels, including social media.

Social

The social component of ESG describes a company’s beliefs concerning issues affecting their employees and society. A few examples include the following:

• Employee training and development
• Policies relating to safety
• Diversity, equity, and inclusion for workers
• Activities to protect consumers through product recalls
• Company’s overarching mission or vision

Companies that emphasize their social commitments believe in acting for the betterment of society.

Governance

Governance policies apply to a company’s business ethics and leadership. Typical factors that fall under this category include:

• Tying executive compensation and bonuses to the company’s performance
• Diversity across the board of directors
• Managing conflicts of interest between the company and the board of directors
• Shareholders’ ability to participate in nominations for the board of directors

Organizations with robust governance policies believe in maintaining transparency with their shareholders.

How does ESG investing work?

To measure a company’s ESG profile, brokerage firms use tools to assess each company’s ESG performance.

Some resources used to measure an organization’s ESG performance include the following.

Global Reporting Initiative (GRI)

Companies interested in reporting their commitment to ESG typically rely on the Global Reporting Initiative (GRI). The GRI is a set of three standards:

1. Universal
2. Sector
3. Topic

Each standard provides a reporting framework that allows companies to report their impact on the environment, society, and economy.

All standards contain specific disclosures companies can use in reporting. Since companies rely on the same standards, it simplifies ESG reporting across different organizations and industry sectors. According to the GRI, nearly four out of five large international companies use the GRI standards in their reporting processes.

Carbon Disclosure Project (CDP)

The Carbon Disclosure Project (CDP) allows companies to define how their activities impact the climate regarding carbon emissions, pollutants, and water usage. To begin the process, customers or investors typically encourage the organization to report its business practices that impact the climate to the CDP. The CDP will provide the company with a questionnaire, which they’ll submit through the CDP’s online reporting tool.

Upon review of the submission, the CDP will issue a letter rating between A and D. The Highest score is A, while a D score signifies that the company is early in its environmental journey. Ratings are comparable across companies.

Dow Jones Sustainability World Index (DJSI)

The Dow Jones Sustainability World Index (DJSI) compiles various stocks from the S&P Global Broad Market Index (BMI) with a history of robust policies concerning ESG. To qualify for the DJSI, companies must display their commitment to the environment and other ESG criteria through their reporting and business practices.

How do you start ESG investing?

You’ll need to follow several steps to reap the benefits of socially responsible investing:

1. Identify the ESG values that are most important to you. For example, if you believe public transportation is critical to protecting the environment and reducing pollution, investing in a company that promotes mass transit may interest you.
2. Start your research on ESG investments. You can perform your analysis independently, allowing you to dive deep into each company’s business practices concerning ESG. However, reviewing company investment materials and websites can be time-consuming.
3. If you want assistance picking your ESG investments, work with a brokerage firm. Most brokerage firms have dedicated financial advisors who can identify stocks with ESG values that align with yours.
4. Decide on the right sustainable investing strategy for you. You can directly purchase stocks in specific companies that align with your beliefs. There are also dedicated ESG mutual funds and exchange-traded funds that pool money from investors toward assets that meet specific ESG criteria.
5. Many investment firms offer ESG funds — essentially, indexed funds with investments in multiple companies, so that you’re diversifying your risk and investing in a way that’s true to your values.

Once you’ve decided on your strategy, you can monitor the results of your investment portfolio and rest easy knowing you’re putting your money toward organizations with similar values.

What are the benefits of socially responsible investing?

There are some advantages to ESG investing.

Align your values with your investment strategy

People with strong feelings about the environment and society will benefit from an ESG investment strategy that aligns with their beliefs. Instead of putting their money toward companies that don’t aim to restrict their carbon footprint or integrate DEI into their business practices, they’ll invest in organizations that do.

Socially responsible investing helps people to earn a return on their investments without doing so at the expense of the environment or their ethics.

Diversify your portfolio

Companies in many different market sectors and industries follow stringent ESG guidelines. It’s possible to thoroughly diversify your portfolio across various market sectors, which ensures a nice balance in your investments.

Portfolios that feature a wide array of investments across assets tend to perform better in the long run than strategies that focus on singular industries or companies.

What are the drawbacks of socially responsible investing?

Despite the many benefits that ESG provides, it does have its imperfections. Here are a few to be aware of.

Dishonest reporting can hide business practices that aren’t ESG compliant

ESG investing is a relatively new concept, and some companies are jumping on the ESG bandwagon early. In reality, adopting ESG-friendly policies is a lengthy process that can take decades to flesh out fully.

Beware of organizations that indicate their commitment to socially responsible policies but don’t provide concrete evidence of their ESG business practices. Check their GRI and CDP reporting history to ensure you’re investing in a company that genuinely aligns with your values. You can also examine their website and past financials for further information about ESG-related activities.

Lack of universal reporting mechanisms

While the GRI and CDP both provide guidance for adopting socially responsible business practices, not every company reports its activities to either organization. There’s a lack of cohesive reporting for ESG endeavors, which makes it difficult to compare companies with one another.

To ensure you invest in companies with similar beliefs, you should thoroughly investigate each company before purchasing shares. Until regulators require ESG reporting or a straightforward ESG rating system becomes available, there’s no simple way to know where a company falls on the social responsibility spectrum.

No guarantee your ESG stocks will perform better than other investment strategies

The goal of most investors is to earn a return on their investment, allowing them to build wealth for the future. While investing in socially responsible companies is admirable, you can’t guarantee their performance against other organizations that don’t fit the ESG mold.

Of course, no one can promise that non-ESG stocks or funds will outperform your socially responsible portfolio, either.

Who should consider ESG investing?

Socially responsible investing is appropriate for anyone seeking to ensure their money goes toward organizations that want to improve the world. By investing in ESG-oriented companies, you can feel good about your investments while potentially earning money. As with any form of investing, however, it’s worth weighing what you can afford to invest — and potentially lose — by following this strategy.

To start your ESG investing activities, determine what’s important to you and seek investments in organizations with similar values.