Environmental, social, and governance (ESG) investing has become a fiercely debated trend within the financial sector. While some view ESG factors as crucial considerations, others argue these criteria are politically motivated and detract from returns. Financial advisors say that personal values, such as ESG, can guide a viable investment strategy. However, they add, investors focused on maximizing returns may also want to consider other factors, such as higher expense ratios charged on many ESG funds, and not restrict themselves only to investment sectors that score relatively well on ESG.
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ESG Background
ESG investing incorporates environmental, social, and governance factors into investment analysis and decisions. For example, ESG criteria may include metrics like a company’s carbon emissions, board diversity, executive compensation and other non-financial elements not traditionally considered in investment analysis.
The concept of ESG investing first emerged in 2005 when the United Nations backed the creation of the Principles for Responsible Investment, a framework to incorporate ESG issues into analysis. However, ESG did not gain major traction until 2017 when large firms like S&P Global began formally integrating these factors into their credit ratings models.
Fund managers also started launching dedicated ESG mutual funds and exchanged-traded funds (ETFs), allocating capital to companies with higher ESG scores. Proponents argued this would incentivize firms to adopt more sustainable practices by tying ESG performance to access to capital.
The ESG bond market surged to over $6 trillion by 2023 as both corporations and governments issued tagged bonds to fund eco-friendly projects. Some companies even reaped a “greenium,” or price advantage, by issuing bonds designated as ESG-compliant. However, recently this price advantage has generally evaporated due to political backlash against ESG investing standards.
ESG Controversy
After years of rapid growth in ESG investing, starting in 2022 political scrutiny of the practice rose into prominence. Critics portrayed ESG investing as primarily motivated by political concerns and a potential drag on returns.
Additionally, some critics have raised concerns about the complexity and reliability of ESG metrics. But much of the backlash is driven by the perception that ESG criteria are biased against certain industries like oil and gas. Critics argue fund managers are prioritizing political goals over generating returns.
A number of states have enacted restrictions limiting how state pension funds can incorporate ESG factors into investments. States have also threatened to pull assets from certain investment managers that have been supportive of ESG investing.
This pushback has tangibly impacted markets. In August 2022, S&P Global stopped including ESG scores in its credit rating methodology altogether in response to investor feedback. The SEC has also announced plans to tighten climate disclosure requirements that some view as linked to ESG.
According to Morningstar research, after surging in mid-2022, investor flows into dedicated ESG mutual funds and ETFs have declined significantly. Companies are also proceeding more cautiously with bonds designated as ESG-aligned.
What This Means for Investors
For individual investors, the rapid emergence of ESG investing and the subsequent backlash raises significant issues. On one hand, limiting ESG considerations could allow for more exposure to certain sectors, like oil and gas, offering potential to boost diversification and returns. On the other, many investors legitimately want to invest in businesses that support their core values.
For Brandon Renfro, a Certified Financial Planner and financial advisor in Longview, Texas, employing ESG to guide investing decisions is not necessarily a negative but is more about personal values than a technical investing matter. “Investments selected on ESG score alone could underperform or outperform a given benchmark during certain periods, which is true of any type of investment chosen based on any other selection criteria,” he notes.
Loraine Z. Montanye, Certified Financial Planner and senior retirement plan advisor at DBR & Co. in Pittsburgh, Pennsylvania, notes that ESG funds often carry higher expense ratios and may not outperform other investments long-term. She suggests an alternative to employing a strict interpretation of ESG investing as the sole guide in constructing a portfolio.
“Our advice to investors who would like to make money while investing according to their values is to look deeper than a fund’s ESG score, as the definition of an ESG investment is largely political with little to no oversight,” she says. “Instead, we would encourage investors to vet to ensure the values of management/investors are consistent with yours, whether you choose to invest in individual companies or through other managers.”
Bottom Line
For retirement investors, the ESG debate introduces another layer of complexity into portfolio construction and fund selection. As ESG-compliant investments have lost some of their value after attracting criticism, weaknesses of ESG investing such as higher fees and limited choices have come into sharper focus. ESG seems likely to retreat from being a sole determinant of an investment’s worth to be one of many factors, including financial fundamentals as well as other personal values.
Investing Tips
- Make a plan with a financial advisor. A financial advisor can discuss your options and provide customized guidance based on your specific priorities and risk tolerance. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you.
- Know your risk tolerance. There’s risk involved with all investments. Your comfort with risk should be inform your investing strategy. If you can’t sleep at night knowing your money is in a certain investment, then it is not right for you.
- Make a budget and project different scenarios. Use SmartAsset’s Investment Return and Growth Calculator to project what your investment portfolio will be worth based on your starting capital, additional contributions, estimated rate of return and investment time horizon. Seeing a plan play out a head of time can help you stick to it in the long run.
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