If you pay attention to the headlines, then you’ve probably heard of ESG investing. With ESG funds capturing $51.1 billion of investors’ net new money in 2020, the headlines are pretty hard to ignore. But what is ESG investing, and is it right for you? Read this article for help in answering those questions.
The ABC of ESG
The term ESG stands for environmental, social, and governance. It is similar to socially responsible investing (SRI) in that you can use it to align your investments with your values. But there are some differences.
While SRI uses screens to include or exclude companies based on an individual investor’s preferences, ESG provides a broader focus based on how a company’s practices in the ESG framework affect that investment.
A number of research groups and companies, including Bloomberg, MSCI, and Refinitiv, provide ESG ratings based on such criteria as:
Environmental: Examples include energy consumption, use of green technology, and animal welfare.
Social: Examples include diversity and inclusion policies in hiring, community contributions, and human rights.
Governance: Examples include board independence, executive compensation, and transparency.
If these issues are important to you, you may want to explore ESG investing. But you should first be aware of potential ESG issues.
Possible ESG Risks and Downsides
Before you call your financial advisor and dive into the ESG investing world, you’ll want to consider the potential drawbacks.
Perhaps the most well-known downside is the lack of any set standards for evaluating companies’ ESG practices. As “What Is ESG Investing?” states:
“While this opens the playing field for many interesting approaches to doing good while generating a solid investment performance, it also increases the possibility that some investment firms will use the veneer of being ESG-focused to acquire new clients without employing disciplined ESG investment strategies.”
It also means that some mutual funds or exchange-traded funds may include a company like Chevron for its environmental record. Others may exclude it since it is in the business of oil and gas, both nonrenewable energy sources.
Or a fund or ETF might include a cellphone provider for its social or governance policies. Yet the company may contribute to environmental degradation through its use of non-biodegradable materials, as “Pros and Cons of ESG Funds” points out.
This lack of widely used standards makes it important to do your research to ensure that your investments align with your values.
You should also be mindful of diversification when investing in an ESG mutual fund or exchange-traded fund. Some funds may be concentrated in industries such as technology. And while owning the FAANG stocks can be a boon for your short-term market returns, holding too much of any sector can place your returns at risk.
Consider talking to a financial advisor about how to offset any concentration so that you maintain a diversified portfolio.
Finally, expense ratios for ESG funds tend to be higher than for other funds. You may think this takes a back seat to aligning your portfolio with your principles. However, it’s essential to keep the cost over time in mind. As Forbes points out, “higher expenses ratios that aren’t associated with at least slightly higher performance may reduce your long-term returns.”
What About ESG Investment Performance?
ESG investments made headlines over the past year, including triple-digit performances for some funds. Yet, as “Keeping ESG Investment Performance in Perspective” states, some top-performing funds started to decline in February 2021 even as the S&P 500 climbed.
Perhaps the decline was a natural correction to the exuberance of the prior year. It’s too soon to tell, but the surge in popularity did prompt the Securities and Exchange Commission to issue a Risk Alert about problematic ESG practices of some investment advisors, Registered Investment Advisors, and private funds offering ESG products.
Recent ESG financial performance also brings up the often-repeated mantra of investing:
Past performance is no guarantee of future results.
ESG investing holds promise, especially for people who want their money to positively impact this world. But we would caution against making any investment because of hype.
Your investment decisions should align with your long-term goals, and your portfolio should appropriately balance the risk you take with your return needs.
A portfolio with EGS investments can be part of that decision-making process and a tool for people who want to reward companies for good behavior.
Consider talking with an investment management firm that can help you determine the specific role environmental, social, and governance equities should play in your portfolio. Our fiduciary, fee-only financial planning firm in Plantation, FL, helps clients determine that role based on their financial picture and objectives.
Schedule a complimentary consultation with one of our fee-only financial planners to discuss your personal situation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.