ESG Investing Explained – Everything You Need To Know

ESG investing has been increasing in popularity and importance over the last few years. But what exactly is it, and does it actually matter? Let’s take a look at all of this and a whole lot more in this article – ESG Investing explained.

What is ESG?

Firstly, what is ESG?

The term “ESG” refers to a single metric that explores three interrelated factors including:

• Environmental responsibility
• Social responsibility
• Governance

ESG is explored at both the macro level – i.e., countries and nations – and micro level (i.e., companies).

Since this article is predominantly focused on ESG investing, we’re only going to focus on ESG at the micro / firm level.

At the firm level then, ESG refers to factors that affect an organisation’s performance such as:

• its impact on people or society, including human rights issues
• its effect on the environment, and
• whether it has good corporate governance practices

These aspects have become increasingly important over recent years because of growing public concern about companies being socially responsible and having positive impacts on communities and the planet.

Investors want to know if these things matter when making investments so they can make informed choices.

They may be looking at investing in companies with strong ESG credentials or avoiding those which do not meet certain standards.

The data driven investors might consider ESG factors in evaluating the relevance of an ESG Investment Strategy.

This now brings us to the idea of ESG investing.

What is ESG Investing?

ESG investing – unlike traditional investing – is not just about making money from investments.

Rather, an ESG investment aims to help ensure you get your money back over time while doing as little damage to the environment and society as possible.

This includes avoiding negative impacts on ESG criteria such as deforestation, water contamination, air pollution, climate change, species extinction, poverty, hunger, war, etc.

The reduction in such negative impacts is achieved by not funding companies that partake in these types of activities.

Companies rely on external financing via debt (e.g., by issuing bonds) or by issuing shares (i.e., equity).

RELATED: What is a Bond?

By not investing in shares of companies with poor environmental, social, or governance policies, ESG investors help reduce the negative impacts of those firms.

What is Impact Investing?

Impact investing can be thought of as a subset of ESG investing. Typically, impact investing tends to focus only on the social and environmental factors (and not the governance ones).

That’s not a hard and fast rule, however.

Impact investing ultimately seeks to address problems caused by poor economic decision-making through alternative approaches.

One approach involves using funds raised via crowdfunding platforms to invest directly into businesses that help solve societal challenges.

Another method uses shareholder activism to encourage change in business models, for example.

Both methods seek to improve the way we live today while creating opportunities for future generations.

What is Sustainable Investing?

Sustainable investing (sometimes also known as responsible investing or “socially and environmentally sustainable investing”), refers to a set of principles that investors use when making decisions about their investments. These include:

• Avoiding companies with negative environmental impacts
• Seeking out companies whose products are made from renewable resources
• Supporting the development of clean energy technologies
• Encouraging corporate social responsibility by corporations in which they invest

Oftentimes, the goal of these practices is to reduce carbon emissions, conserve natural resources, promote fair labor conditions for workers around the world, and support communities where businesses operate.

In addition to avoiding certain types of business activities, there are other ways in which an investor can make her/his portfolio more sustainable.

For example, some funds will seek out stocks that have been certified by third-party organizations such as the CDP (formerly, the Carbon Disclosure Project) or Dow Jones Sustainability Indices.

Other funds may focus on specific industries like agriculture or forestry, for example.

There are many different approaches to sustainability investing, but they all share one common theme — the desire to do good while doing well financially.

Okay, now that you understand what ESG Investing is, let’s dive deeper into what makes up “ESG” itself.

Put differently, what affects the ESG of companies and investments?

What Affects the ESG Rating of Companies and Investments?

While there are a multitude of factors that contribute to companies’ ESG rating, and the list of ESG criteria is ever increasing, we think it’s fair to say some aspects are evergreen, including:

• the company’s involvement in or partaking in corruption
• whether the company’s products have caused pollution
• whether the company uses child labour
• the company’s tax policies (e.g., whether it’s avoiding or evading taxes)
• whether the company respects human rights

This just about scratches the surface of what impacts or affects the ESG rating of companies.

In a nutshell, you can think of it as actions by the company which may affect the environment, society at large, or the ethical and legal workings of the business itself.

Is ESG Investing Right For Me?

The short answer – only you know if it’s right for you.

ESG investing is not just about earning a financial return.

It’s very much a case of aligning your financial goals with your personal values in the context of sustainability and social and environmental responsibility.

But if you’re not entirely sure, then here’s the longer answer.

Traditional vs ESG Investing

Traditional investing focuses predominantly on the risk and (expected) returns of securities.

Broadly speaking, it fails to account for important aspects of corporate behaviour such as sustainability, ethics, transparency, accountability, community involvement, employee relations, product safety, etc.

There are exceptions to this. For example, Corporate Finance (one of the major realms within “Finance”) places great importance on “reputation risk”.

Companies with poor transparency, weak accountability, unethical practices, etc can end up hurting their reputations.

That in turn can decrease the trust investors have in the firm.

But despite the consideration of things like reputation risk, ESG investing tends to place far greater importance on these non-financial factors vis-a-vis traditional investing.

ESG funds for instance, seek out companies that behave responsibly and invest in those companies.

They look at everything from the way a company treats employees to the impact of its operations on local communities.

They actively avoid investing in companies with poor governance or social and environmental responsibilities, for example.

A traditional mutual fund on the other hand, will largely focus its efforts and attention on optimising risk-adjusted returns.

Stability of Portfolio

Some anecdotal evidence suggests that ESG funds tend to hold onto their holdings longer than traditional mutual funds.

So, if you’re looking for ways to add stability to your portfolio, then ESG funds could help.

Importantly, the same could be said about an ETF or index fund that tracks the overall stock market index.

Responsible Diversification

ESG funds offer another option – responsible diversification.

You’ll still benefit from diversification across different sectors and industries, but now you’ll also gain access to a wider range of companies.

And since they focus on responsible investment rather than simply picking winners, you can rest assured that you won’t end up supporting companies that cause harm to others.

What Should I Consider Before Choosing an ESG Fund?

Before deciding which type of ESG fund to buy or deciding to implement ESG investing, take into account several factors including:

The size of your current or future financial goals. Remember that ESG investing doesn’t focus exclusively on generating the highest return. This could be detrimental to your longer term financial goals in that you may not earn the highest return you could.

Your tolerance for volatility. Some people prefer low levels of volatility while others can cope with higher levels. While higher volatility and risk doesn’t necessarily mean higher returns, there certainly is a positive relationship between risk and return. On a related note, we recommend reading our article on Why Equities Are Volatile.

How much capital growth you want to achieve. This is somewhat similar to the point about financial goals above. But additionally, note that firms with high environmental and social responsibilities may have lower growth because they don’t necessarily always find the most lucrative projects to invest in.

Your personal values. Fundamentally, do you really care about environmental issues, animal welfare, human rights, climate change, etc.? Or do you just want to maximise your return? If it’s the former, ESG investing is a great way to align your personal values with your financial goals. If it’s the latter, then it’s probably not a good fit for you.

Are There Any Downsides to Using ESG Funds?

Of course! There will always be some risk associated with buying shares – even those of responsible companies.

The main downside is that ESG funds typically charge higher fees compared to conventional ones.

The fees are arguably justified, too. It costs money to research and find companies with good environmental, social, and governance policies, for example.

Wrapping Up

With ESG investing explained in detail now, we hope you have a clearer understanding of what exactly it is and whether it’s a good fit for you.

If you want to explore ESG investing in more detail, or if you want to statistically test and validate the impact of ESG investing and analyse investments using ESG as a basis, then check out our Data Driven Investing (with Excel) Course.

We create an “ESG factor” in the course (within the theme/realms of Factor Investing) to guide the investment decision making. And we find some pretty interesting results 😉