ESG stands for environmental, social, and governance.
ESG investing can be utilized by responsible citizens and funds to analyze the companies based on some qualitative aspects which are not present in the financial statements, like identifying the impact of climate change on the balance sheet; or even the business ethics. It is one of the important investing methods in responsible investing and is gaining traction.
Increasing research is showing that this method can reduce portfolio risk and generate competitive returns. Combining ESG investing with traditional stock analysis is known as ESG integration.
ESG funds are the funds that invest in equities and bonds of companies after assessing them on environmental, social and governance factors.
Let us now study the three components of ESG investing:-
E is for environmental
Environmental criteria research the elements that demonstrate a company’s impact on the Earth in both positive and negative ways.
Reduction in forest cover, rise in global temperature pollution of rivers and air are some of the ways where humans are neglecting the environment. This has resulted in erratic rains, droughts, and flooding. How the company deals with environmental issues is one of the aspects here.
It can include research on-
· Compliance with government environmental regulations.
· The company’s meeting of greenhouse gas emission goals.
· Optimum use of water and conservation. Eliminating water pollution.
· Contamination of land concerning the disposal of hazardous waste.
· Natural resource conservation and treatment of animals.
· Recycling of important resources and the use of renewable energy like wind and solar.
· Plans and policies for keeping the environment safe and healthy.
Nike is a company that meets the environmental criteria of ESG. Its sustainability report uses the GRI framework, SASB, and Sustainable development goals (SDG) of the United Nations that provide valuable information to the investors.
S is for Social
Social criteria look at the company’s business relationships.
· Do the suppliers of the company hold the same values as that of the company?
· History of consumer protection issues, consumer friendliness, and customer service responsiveness.
· Does the company donate a percentage of its profits to the local community and encourage its employees to perform volunteer work. As an example; Employees help in emergencies in a society like floods.
· Employee payment and perks, training, and development.
· Employee health and safety and preventing sexual harassment.
G stands for corporate governance.
Corporate governance relates to shareholder friendliness, the board of directors, and how the business is run. It is about the integrity and honesty of the management. This also relates to wealth creation for the investors in the long run.
· Composition of board of directors, also diversity of the board of directors.
· Conflict of interest in the choice of board of directors.
· Compensation of executives and their bonuses and perks.
· Transparency of accounting methods.
· Involvement of shareholders in voting on important issues. Complete transparency in communications with shareholders.
· If any political contributions are made to obtain favorable treatment.
· History and relationship at the stock exchange and other regulatory bodies.
For example, Boston-based Trillium Asset Management ESG criteria are excluding companies with exposure to coal mining and those companies with part of their revenues from weapons. It also avoids investing in companies with corporate governance issues and workplace discrimination.
Investment strategies related to ESG Investing
· Socially Responsible Investing-
Socially responsible investing emerged in the 1970s and emphasizes strategies relating to sustainable, responsible, and impactful investing. It has grown in popularity over time as it takes care of all the stakeholders like employees, customers, distributors, suppliers, and the environment as against only the shareholders.
SRI investors use certain filters or criteria to screen out companies that do not meet their value criteria. It may be the weapon stocks, alcohol, or the tobacco industry.
· Impact investing-
It comes under socially responsible investing. Investors put their money in companies that have a positive environment and social impact. Some may be happy with below-market returns while others are happy with comparable or even better returns. An example could be an area like boosting sustainable agriculture which is good for poor farmers.
· Conscious capitalism-
Conscious capitalism is a socially responsible economic and political philosophy created by John Mackey and Raj Sisodia. Proponents believe businesses should operate ethically by serving the interests of all stakeholders involved — not just corporate management and shareholders.
The four guiding principles behind conscious capitalism include a higher purpose, stakeholder orientation, conscious leadership, and conscious culture.
Till now we have seen that socially responsible investing excludes companies that don’t meet their criteria in certain aspects like the defense industry or sin stocks like gambling, alcohol, and tobacco. But a distasteful company could be a high ESG company.
As an example, a defense company that produces missiles and tanks and scores high on environment sustainability, employee treatment, and corporate governance may be included in an ESG fund.
But some other ESG investors may screen out entire industries.
Growth in ESG Investing
ESG and SRI are growing at a very fast pace and are catching on with financial institutions and everyday investors. According to the US SIF foundation’s 2020 Report on US Sustainable and Impact Investing Trends, as of year-end 2019, $17.1 trillion — was managed according to sustainable investing strategies.
This is becoming popular because millennial’s tend to crave social responsibility. Baby boomers are expected to pass around $30 trillion to the future generation.
Morgan Stanley’s Institute for Sustainable Investing conducted studies in 2017 and found that 86% of millennial’s are interested in sustainable investing in companies or funds that aim to generate market-rate returns while pursuing social and environmental impact.
Pros and Cons of ESG Investing-
· If values are important, socially responsible investing allows you to put money where your mouth is. You are walking the talk. Pick a few socially responsible funds and be at peace.
· These funds withhold money from companies that are not behaving. This may force the companies to shape up. It is like punishing them. No change would happen in society if you don’t take a stand.
· It rewards companies that are doing the right things. If you want companies to be responsible, you have to reward them with investments. In the long term, it can act as a catalyst for social change.
· By investing in socially responsible funds which align with your values, you will sleep better at night knowing fully well that you are doing something right in this world. The happiest feelings will come when the companies will make profits and make good returns on your investments.
This will be a win-win situation for both.
· When you invest in socially responsible funds you might have to give up on high returns. Ethics will become more important than performance. When socially responsible investing becomes the primary objective, the financial side of the equation may suffer.
· ESG ratings often display a size bias that gives larger firms better ESG scores on average. This does not necessarily mean that larger companies take better care of the environment or society.
Nowadays a large number of investors are placing billions of dollars into socially responsible funds, the ESG funds. These funds select stocks based on a company’s ESG practices along with the traditional financial measures.
This has generated a new family of Exchange-traded funds (ETFs) that have a focus on investing criteria for social good. The impact investing securities has outperformed the broader market over the last year. The ETFs with the best 1 year trailing returns are FAN, AIA, and GRID.
There is 16 impact investing ETFs in the US with an ESG score of 8 out of 10. Impact investing securities as measured by the S&P 500 ESG Index have outperformed the broader markets with a return of 20.4% over the last year compared to the S&P 500 total return of 19.7%.
The best impact investing funds based on performance over the last year is the First Trust ISE Global Wind Energy Index Fund(FAN), ishares S&P Asia ETF (AIA), and First Trust NASDAQ clean edge smart grid infrastructure index fund(GRID).
First Trust ISE Global Wind Energy Index Fund
It has assets under management of $483.6 million and tracks the ISE Clean Edge Global Wind Energy Index, an index designed to provide exposure to the performance of companies primarily engaged in the wind energy industry. The fund invests in both growth and value stocks in the wind energy sector.
iShares S & P Asia ETF(AIA)
It has assets under management of $3.1 billion. AIA tracks the S & P Asia 50 Index, which follows the 53 leading companies from China, Hong Kong, South Korea, Singapore, and Taiwan. The fund invests in growth and value stocks and the companies that comprise the fund include information technology, financials, and the communications sector.
First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund(GRID)
It has assets under management of $198.2 million and tracks the NASDAQ OMX clean edge grid infrastructure index, which is designed to gauge the performance of the grid and electric energy infrastructure sector. It has exposure to companies that are engaged in maintaining and operating the electric grid, electric meters and devices, networks, and energy storage and management.
In the ’70s Milton Friedman popularized the shareholder value theory which argued that the company’s only social responsibility was to maximize shareholder value i.e. to make money for the shareholders holding the stock.
It is quite understandable as lack of profits can lead to bad outcomes for the company, but the businesses can run into serious trouble if the management is only concerned with short-term profit measures.
If this philosophy percolates down the company’s culture, the employees will make poor decisions or even illegal dealings to keep the management happy in the short term. This may open the company to lawsuits or investigations.
If you are passionate about things that matter to you and want to invest in companies that match your morals, then ESG investing is the right fit for you. Search for ESG ETFs that match your ambitions and beliefs and when they perform it would be rewarding for you. We can then rightly say that ESG investing has become an important part of investing process.