What is ESG Investing?

ESG stands for Environmental, Social and Governance. It’s a way to evaluate public companies – in addition to financial research – to decide whether they are good investments. Each category has different criteria, but they all add up to a goal of selecting investing that have the ability to perform well, by doing good.

Investors may be familiar with SRI, which stands for Socially Responsible Investing. SRI investing has been around since the 1960s, and several different types of investing fall under the umbrella, including ESG. For both, it is fundamentally about performing research on public companies by establishing various screens that determine whether the stock being analyzed meets the criteria the investor is looking for. The difference between ESG and SRI is that where SRI screens out investments that don’t meet certain criteria, ESG screens are about actively identifying companies to invest in that meet these criteria in addition to financial or other stock considerations.

By looking for companies that meet certain ESG criteria, investors are focusing at the company level. This means that certain industries, such as defense production, that might be excluded by an SRI screen would be included in an ESG portfolio if they scored well on environmental, social or governance criteria. Investors can of course still opt out of investing in certain industries, but this example demonstrates the different mindsets involved. To some, and perhaps you, maximizing your retirement may include investing in what you see as morally correct.

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The History of Investing by Looking Beyond Shareholder Value

Beginning in 1970, Milton Friedman popularized the shareholder value theory which holds that a company’s only social responsibility is to maximize shareholder value.  In practice, this often becomes the pursuit of short-term profits. This, in turn, can potentially lead to behavior that erodes good management and can potentially put a company at risk – reputational risk, regulatory risk, labor risk, and a whole host of other problems.

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A Strategy For Risk Reduction

Beyond the obvious social benefits of adhering to the tenets of ESG, companies – and investors – have begun to embrace this type of investing because it tends to reduce risk. As investors demand more accountability from companies, it has become increasingly more common for companies to disclose their ESG related risk and the activities they undertake to manage them  in their mandated financial reporting.

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But Does It Create Value?

According to recent research, the answer is a resounding “yes.” According to Gallup, companies that prioritize treating their employees well achieve per-share earnings growth more than four times higher than rivals. Top-quartile companies on metrics of employee engagement generate high generate higher customer engagement, higher productivity, better retention, fewer accidents, and 21% higher profitability when compared to bottom quartile companies.

The same is true when it comes to building a diverse workforce. A McKinsey study from 2018 examined 366 public companies and found that those in the top quartile for gender, racial, or ethnic diversity are more likely to generate financial returns above the national medians for their industry.

It makes sense that companies willing to invest in the type of long-term, committed planning and implementation that successful ESG investing requires will also be well-run, as the two attributes go hand-in-hand.  And to an investor, a well-run company that can be included as part of a long-term portfolio management strategy will be enticing.

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Deploying ESG in Your Portfolio

ESG is part of comprehensive stock research.  If you are a self-directed investor who builds a portfolio based on single-stock exposures, you should already be familiar with the work you need to do to understand a company. While some ESG information will be included in company reports, to gain perspective across companies you’ll need to look at sustainability reports that adhere to a respected global standard, such as the Global Reporting Initiative (GRI) and Principles for Responsible Investment (PRI).

You can also find mutual funds and ETFs that focus on ESG investments, as well as work with asset managers that create their own ESG portfolios.

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The Bottom Line

Whether you choose to add ESG investments as one piece of your entire portfolio, or make it the basis for your investing strategy, there’s a lot to choose from. Having some guidance along the way can ensure that your goals are met.