Environmental, social and governance (ESG) investing offers investors a way to grow their portfolio while doing good. This investment strategy has two goals: generating a financial return while also promoting a positive impact for the environment, social issues and corporate governance. If you’re interested in investing in companies that align with your values, an ESG approach may be a good fit.
ESG Investing Defined
Investing with ESG strategies is about focusing on three specific aspects of a company to decide if it’s one you want to support. Also known as sustainable, green or impact investing, ESG means looking beyond a company’s bottom line and examining how it affects the world at large in these ways:
1. Environmental impact
The “E” in ESG stands for environmental. Evaluating companies using these criteria means looking at what steps it’s taking to reduce its carbon footprint and promote environmental protections. For example, if you’re looking for green companies to invest in, you might consider things like its:
- Use of green technologies, such as solar or wind energy
- Efforts to conserve water and other natural resources
- Greenhouse gas emissions and air quality
- Use of hazardous materials and waste management policy
- Recycling practices
- Support of organizations that promote conservation or pollution reduction
Essentially, you’re looking for companies that are doing something to help promote a healthier environment, either directly or indirectly.
2. Social impacts
“S” is for social and for investing purposes, it refers to companies that actively encourage good relationships with their employees, consumers and the broader community. You can measure a company’s social impact by considering things like:
- How they treat their employees and the overall company culture
- Employee pay, benefits and other perks
- Emphasis on training and the development of a skilled workforce
- Employee policies regarding safety and sexual harassment
- Diversification in hiring and equal employment opportunities
- Relationships with consumers and whether the company has a history of complaints or lawsuits
Companies can also be measured using the social criteria based on what they’re doing in their local communities or on a global scale. For example, a company that supports local charities or advocates for fair pay for workers in other countries could fit the ESG label.
3. Governance impacts
Governance refers to how the company itself is managed. Specifically, it means creating an environment that’s friendly to shareholders rather than serving only the interests of the board of directors or higher-ups. Determining whether a company is focused on good corporate governance means weighing:
- The diversity of its board and management team
- Voting rights among shareholders and directors
- How executive pay and benefits compare to average employee pay and benefits
- How transparent its accounting practices are
- The company stock structure
- How ethical its business practices and standards are
- Regulatory history and whether any complaints or lawsuits have been filed against it
A company that practices good governance can be characterized by a diverse board that’s inclusive of women and minorities, transparency when it comes to accounting and financial reporting and executive compensation that’s tied to revenues rather than some arbitrary metric.
ESG vs. Socially Responsible Investing
ESG investments are often grouped in with socially responsible investments but they aren’t quite the same. When you’re investing through the ESG lens, you’re taking an inclusive approach meaning you’re screening in companies whose fundamentals fit the definition of ESG.
Socially responsible investing or SRI, on the other hand, is exclusive, meaning you’re screening out companies that don’t fit the profile. For example, instead of looking for a company that has a solid track record of promoting green energy you might automatically refuse to invest in companies in certain industries, such as gun manufacturing or gambling.
ESG investing is about finding the companies that further your values using positive screening. SRI is more about avoiding the ones that don’t. It’s a subtle difference, but it’s important to understand if you’re trying to build a portfolio around environmental, social and governance issues.
Benefits of ESG Investing
Investing based on environmental, social and governance issues can appeal to investors on several levels. The obvious reason to give it a try is having an opportunity to do something that benefits the greater good, while also getting a financial benefit in the form of investment returns.
For example, if you’re concerned about climate change, fair pay for workers or encouraging ethical business practices, then investing in ESG companies can help you further those causes.
Risks of ESG Investing
The biggest risk factor associating with taking an ESG approach is that there are no standardized rules or regulations for companies to follow. In other words, any company can call itself sustainable to attract investors.
A strategy called greenwashing can be used to market a company as being sustainable or green when it really isn’t. That means you could end up investing in a company that you think supports the same causes you do but in reality, it could have completely different values.
The Bottom Line
The most important thing you can do when choosing ESG investments for your portfolio is research companies carefully before investing in them. The more transparent a company is in publishing sustainability reports or making its financial statements available to the public, the better. These documents can help you get a better sense of how committed a company is to ESG practices and what impact they’re making with regard to the environment, social issues and corporate governance.
Tips for Investing
- Consider talking to your financial advisor about the benefits and potential drawbacks of using an ESG investment strategy. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Keep in mind that there are different ways to pursue ESG investing, something that is becoming more popular. You could purchase individual stocks, for example, or invest in ESG mutual or exchange-traded funds. If you’re considering ESG mutual or exchange-traded funds, take time to look under the hood at the underlying investments to make sure the holdings are diversified enough to avoid becoming overweighted in one company or sector.
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