There is a lot of pressure on publicly-traded companies to not only increase their earnings year after year, but to expand their social and environmental awareness. This pressure includes Environmental, Social and Governance (ESG) investing, which continues to gain steam among investors. For many, the purpose of ESG investing is not only to realize a return, but to encourage sustainable business practices among public companies while allocating capital for the benefit of society and the environment.
ESG Investing Explained
Generally, ESG investing is where the examination of environmental, community and other corporate and societal governance criteria comes into play in portfolio construction and investment analysis. ESG investing is a term that that falls under the broad umbrella of Socially Responsible Investing (SRI), which also includes impact investing, and is often referred to as ethical investing, among other terms. (For more, see: 3 Trends to Watch in ESG Investing.)
The primary theory behind ESG investing is that it delivers more than just a financial return for its investors. It enables individuals to become positive agents of change within publicly-traded companies who, seeking to be included in SRI funds, are then encouraged to adopt responsible and socially conscious practices. These practices include promoting gender diversity on their boards of directors, issuing detailed reports on sustainability, implementing sustainable forestry practices, improving climate risk disclosure, setting greenhouse gas emission reduction goals, addressing poor labor and human’s rights conditions in their global supply chains and adopting goals to reduce energy use or to use renewable energy.
Investing in ESG ETFs
The earliest proponents of socially responsible investing were high-net-worth individuals and large institutions. Now the trend has moved toward retail investors because of the availability of ESG exchange-traded funds (ETFs). ETFs generally have lower expense ratios than their mutual fund counterparts. A rise in demand from retail investors for low cost ESG ETF options has led to an expansion of the space.
In the past, ESG investors had to buy individual stocks that met certain ESG criteria or pay internal expense fees of up to 1.16% to participate in broad-based ESG mutual funds like the Domini Social Equity Index Fund (DSEFX). The high cost of ESG mutual funds is due in part to the ESG screening process which adds another layer of research costs for fund managers. However, the actively-traded nature of funds, such as the DSEFX, is the biggest contributor to high expense ratios.(For more, see: ESG ETFs Look to Catch Traditional Rivals.)
For retail investors who take a passive asset class approach, 2016 produced an abundance of opportunities for cost and tax-efficient ESG ETFs. In 2016, there was a doubling of ETFs, with 21 funds launched that focus on ESG criteria. In September of 2016, Morningstar data reported that ESG fund assets grew an astonishing 76% over five years to $201.3 billion under management.
For many, the question of performance remains. The primary concern for investors is whether an ESG portfolio can deliver returns comparable to non-ESG portfolios. While many would argue that the purpose of the markets is purely commercial, the incorporation of ESG factors into business analysis has proven to be a good investing practice. In 2015, Deutsche Asset Management and Hamburg University conducted a meta-analysis of over 2,000 empirical studies and found a positive correlation between ESG standards and corporate financial performance.
ESG does not have to be a stand alone asset class. Instead, it can be considered as an additional layer of analysis to portfolio construction. Part of creating a socially responsible portfolios includes screening out companies that are currently involved in controversies, or those that have a negative social or environmental impact, including tobacco, gambling, civilian firearms, military weaponry, nuclear power businesses and genetically modified organisms.
The popularity of socially responsible investing continues to grow. More funds are being rolled out to meet the demand, which means more choices for investors. (For more, see: How ESG, SRI and Impact Funds Differ.)
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